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RSI





THE RELATIVE STRENGTH INDEX


 The relative strength index was created by J. WELLES WILDER JR in late 1970s. RSI is a momentum indicator that compares the price of a security relative to itself and relative to its past performance. The RSI is less volatile than the ROC, because the RSI takes the average of the up and down days, its results are less affected by a sharp dip or rise on a specific day. As a result, this method tends to be a more stable momentum indicator than the ROC calculation.

 RSI is a tool which can add a new dimension to chart Interpretation when plotted in conjunction with the original price chart. Some of these Interpretative factors are:

-           TOPS and BOTTOMS are indicated when the RSI goes above 70 or drops below 30.
-          CHART FORMATIONS which often show up graphically on the RSI may not be apparent on the bar chart
-           FAILURE SWINGS above 70 or below 30 on the RSI scale are strong indications of market reversals.
-          SUPPORT and RESISTANCE often show up clearly on the RSI before becoming apparent on the bar chart
-          DIVERGENCE between the RSI and price action on the chart is a very strong Indication that a market turning point is imminent.

The RSI is a Momentum Oscillator:

 The momentum oscillator measures the velocity of directional price movement. Note the Interaction of the oscillator curve and the price curve. The oscillator appears to be one step ahead of the price; the reason being that the oscillator, in effect, is measuring the rate of change of price movement.

How RSI is calculated?

                       



For the first calculation of the Relative Strength Index, RSI, we need the previous 14 days close prices. From then on, we need only the previous day's data.

 The initial RSI is calculated as follows:

 (1) obtain the sum of the UP closes for the previous 14 days and divide this sum by 14. This is the average UP close.
 (2) Obtain the sum of the DOWN closes for the previous 14 days and divide this sum by 14. This is the average DOWN close.
(3) Divide the average UP close by the average DOWN close. This Is the Relative Strength (RS).
(4) Add 1.00 to the RS.
(5) Divide the result obtained in Step 4 into 100.
(6) Subtract the result obtained in Step 5 from 100. This is the first RSI.
    From this point on, it is only necessary to use the previous average UP close and the previous average DOWN close in the calculation of the next RSI. This procedure, which incorporates the dampening or smoothing factor into the equation, is as follows:
  - To obtain the next average UP close: Multiply the previous average UP close by 13, add to this amount today's UP close (if any) and divide the total by 14.
 - To obtain the next average DOWN close: Multiply the previous average DOWN close by 13, add to this amount today's DOWN close (If any) and divide the total by 14.
Steps (3), (4), (5) and (6) are the same as for the Initial RSI.

Why do I need to know this?

Platforms software do the whole work, and afford us the RSI and other thousands of indicators ready to use plot in the chart and manipulate easily. 
However, learning how such an indicator is calculated helps traders get a full understanding of how it works and what its signals mean.   

What the Relative Strength Index indicates?

Tops and Bottoms :


These are indicated when the Index goes above 70 or below 30.

The Index will usually top out or bottom out before the actual market top or bottom, giving an indication that a reversal or at least a significant reaction is Imminent.

Chart Formations:


 The Index will display graphic chart formations, which may not be obvious on the price chart. For instance, head and shoulders tops or bottoms, pennants or triangles often show up on the Index to indicate breakouts, and buy and sell points.

Failure Swings:


Failure swings above 70 or below 30 are very strong indications of

a market reversal. (See Fig. 6.3 and Fig. 6.4.)

    

Support and Resistance:


Areas of support and resistance often show up clearly on the Index before becoming apparent on the price chart. In fact, support and resistance lines drawn using index points are often analogous to trend lines drawn using bar or candlestick chart points.

Divergence:

Divergence between price action and the RSI is a very strong indicator of a market turning point. Divergence occurs when the RSI is increasing and the price movement is either flat or decreasing.
 Conversely. Divergence occurs when the RSI is decreasing and price movement is either flat or increasing.
A divergence signals a waning of momentum. It does not necessarily signify new momentum in the opposite direction. Divergences appear frequently in uptrends and downtrends in response to the tug-of-war between those trying to drive momentum further faster and those betting against it. Again, there are many divergences in a trending market, but only one of them will end up signaling the end of the trend.
As such, divergences are best thought of first and foremost as warnings to exit, and second as opportunities for a reversal.
Overbought or oversold conditions in a bull or bear market do not generate meaningfully reactions unless preceded by divergences.
One of the first signs of reversals is that a short-term oscillator reaches an extreme that has not been seen since the previous bear or bull market.

Famous mechanical RSI trades:

Ø  Equilibrium crossovers :   
                -    buy when above 50, sell when bellow.
Ø  Buyer only :
-          Entre long: RSI < 30 reversing towards the upward.
-          Close long: RSI > 70 reversing towards the downward.

conclusion

The RSI is still a popular tool for spotting divergences and for warning traders of overbought and oversold conditions. The RSI has become less widely used for its ability to create chart patterns, and traders have since learned that overbought and oversold conditions do not in and of themselves indicate market tops and bottoms.
One way of thinking about the RSI is that it compares the bullishness of bullish sessions to the bearishness of bearish sessions, using points gained or lost as the gauge of “how bullish is bullish/how bearish is bearish.” That differs from the way the stochastic measures bullishness or bearishness, but in both instances the technical indicators are looking forward to determine which of the two forces, those betting on higher prices or those betting on lower prices, is in control of the market.

Sources:


-          New Concepts in Technical Trading Systems, By J. WELLES WILDER JR
-          Technical analysis explained, BY MARTIN PRING



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