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Relative Strength IndexThe Relative Strength Index (RSI) is a very popular oscillator that was developed in 1978 by J. Welles Wilder. The RSI measures the internal strength of a security and is calculated by comparing the average upward price change with the average downward price change over a set number of periods. A 14 day RSI is popular and the fewer number of days you use, the more erratic the indicator becomes. The formula for the calculation of the RSI is:
where: U = An average of upward price change The Relative Strength Index is plotted on a chart as depicted below:
The RSI is plotted between the values of 0 and 100 and has reference lines placed at 30 and 70. The RSI can be interpreted a number of ways which include crossing the reference lines, i.e. when the RSI crosses up above 30, then buy and when the RSI crosses down below 70, sell. The RSI measures the internal strength of a security and does not compare the strength to another security or benchmark, as the name may suggest. Like many oscillators, probably its greatest advantage is identifying divergence. Divergence occurs when the price of a security moves in one direction however the indicator fails to follow. For example, a security may form a higher peak than the previous peak however the RSI may form a lower peak. This would point towards the security lacking strength and a likely fall. Other interpretations include identifying chart patterns in the RSI plot like head and shoulders and support and resistance. These patterns may be more obvious with the RSI than the security’s chart and can provide some indication of potential movement.
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