RSI

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RSI

Subject: Relative Strength Index (RSI)

Written by: Mystifier

August 8th,1999

The Relative Strength Index is regarded by some technicians as the second strongest indicator in technical analysis. Some say its tied with the strongest indicator.....MACD. I think it is definitely one of the strongest and most useful of TA tools. It is great for helping traders identify classic charting patterns like trendlines, support and resistance, and head and shoulders patterns better and quicker than other indicators and even before the price chart.

Interpretation

RSI is an oscillator (meaning the value "oscillates" between 0 and 100), that measures the strength of a stock or index by measuring changes in its closing prices, which is very important because traders pay more attention to closing prices than to any other prices. It is considered a "leading indicator", meaning it usually makes significant changes before price movements. Usually oversold and overbought reference lines are drawn in at 30 (oversold) and 70 (overbought), but these levels can and should be adjusted for bull or bear markets. I like to use an 8 period RSI, but one can use anywhere from a 6 to14 period. Trading signals using shorter periods will become more visible.

Below is a weekly chart of the Nasdaq composite index with the RSI indicator drawn in below:

Trading Rules

RSI gives three types of trading signals. The strongest is the RSI divergence, then charting patterns, and then the level of RSI.

Bullish or bearish RSI divergences normally occur at major tops and bottoms. They show when the trend is ready to reverse. A bullish divergence occures when prices fall to a new low but the RSI indicator does not dip as low as its previous dip. Buy as soon as RSI turns up from its second dip (after price has reached a new low), and place a protective stop below the latest minor low. Buy signals are especially strong if the first RSI bottom is below the lower reference line (usually the 30 line) and the second bottom is above that line.

A bearish divergence occures when prices hit new highs but the RSI indicator traces a lower peak than the one before it. Sell short as soon as the RSI indicator turns down from its second top, and place a protective stop above the latest minor high. NOTE: On the chart above 2 excellent examples of bearish divergences can be found........and the resulting downturn that occured after. The first is in mid 1998 where price peaked and RSI traced a lower top. If you would have sold short after the second smaller peak in RSI odds are you would have banked large. The next bearish divergence is occuring as of this writing. Notice the early RSI peak in 1999 and the lower peak that is being formed now. This is a classic RSI bearish divergence and says that lower prices may be coming. Also notice how well RSI pointed out where support could be found.

Trendlines, support and resistance, and head and shoulder patterns work great with RSI. RSI will usually complete these patterns before price patterns. When RSI breaks its downtrendline, place an order to buy above the trendline in order to catch an upside breakout. When it breaks its uptrendline, place an order to sell short below the trendline in order to catch a downside breakout.

When RSI rises above its upper reference line, it shows that the market or stock is strong but its overbought and entering a sell zone. When RSI declines below the upper reference line sell short.

When RSI falls below its lower reference line, it's a sign of weakness but the stock or market is oversold and entering a buy zone. Buy when prices rally above the lower reference line.

Mystifier

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