The relative strength index (RSI) is a technical indicator used in the analysis of financial markets. A technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.
It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period. The indicator should not be confused with relative strength.
The RSI is classified as a momentum oscillator, measuring the velocity and magnitude of directional price movements. Momentum is the rate of the rise or fall in price. The RSI computes momentum as the ratio of higher closes to lower closes: stocks which have had more or stronger positive changes have a higher RSI than stocks which have had more or stronger negative changes.
The RSI is most typically used on a 14 day timeframe, measured on a scale from 0 to 100, with high and low levels marked at 70 and 30, respectively. Shorter or longer timeframes are used for alternately shorter or longer outlooks. More extreme high and low levels—80 and 20, or 90 and 10—occur less frequently but indicate stronger momentum.
When price moves up very rapidly, at some point it is considered overbought. Likewise, when price falls very rapidly, at some point it is considered oversold. In either case, Wilder deemed a reaction or reversal imminent.
RSI Formula:-
Interpreting Failure Swings: -
Wilder thought that "failure swings" above 70 and below 30 on the RSI are strong indications of market reversals. For example, assume the RSI hits 80, pulls back to 71, then rises to 81. If it falls below 71, Wilder would consider this a "failure swing" above 70.
Andrew Cardwell has developed several new interpretations of RSI to help determine and confirm trend. First, Cardwell noticed that uptrends generally traded between RSI 40 and 80, while downtrends usually traded between RSI 60 and 20. Cardwell observed when securities change from uptrend to downtrend and vice versa, the RSI will undergo a "range shift."
Next, Cardwell noted that bearish divergence: 1) only occurs in uptrends, and 2) mostly only leads to a brief correction instead of a reversal in trend. Therefore bearish divergence is a sign confirming an uptrend. Similarly, bullish divergence is a sign confirming a downtrend.
Reversals
Cardwell discovered the existence of positive and negative reversals in the RSI. Reversals are the opposite of divergence.
For example, a positive reversal occurs when an uptrend price correction results in a higher low compared to the last price correction, while RSI results in a lower low compared to the prior correction.
A negative reversal happens when a downtrend rally results in a lower high compared to the last downtrend rally, but RSI makes a higher high compared to the prior rally.
In other words, despite stronger momentum as seen by the higher high or lower low in the RSI, price could not make a higher high or lower low. This is evidence the main trend is about to resume. Cardwell noted that positive reversals only happen in uptrends while negative reversals only occur in downtrends, and therefore their existence confirms the trend.
Practical understanding through trading over the years & effective trading ranges: -
1) It is always better to work on RSI of 27 days rather than 14 days for 73:28
2) Positive ranges results in buy on dips near 40 RSI but not sell at 80. When I say buy on dips, it would be more fruitful to sell a far OTM Put or bullish derivative strategy near RSI of 40 rather than buying future.
3) Negative ranges results in Sell on Rise near 60-65 but not buy at 20. When I say sell on rise, it is far better to sell far OTM call or bearish derivative strategy than selling future.
4) It is always safe to work on 14 days RSI of 85:15 on stocks with good liquidity
5) Conventional 14 days RSI of 80:20 works well on indexes
Thank you. Comments and feedback would be appreciated.
