Having a tool to measure the speed and change of the price movements is invaluable to those working in stocks & technical analysis, which is why John Welles Wilder Jr. came up with the relative strength index (RSI) all the way back in a 1978 book published by him.
But what is RSI, and how is it used? To help you figure that out, I’m gonna go into detail on this system and help you better understand it.
Understanding Relative Strength Index (RSI)
The relative strength index (RSI) indicator is used to measure momentum in technical analysis, and is able to give an idea of a security’s recent price changes and evaluate the conditions of said changes. It can be used to tell you whether the security’s price is being overvalued or undervalued.
The price chart is displayed as an oscillator, or a line graph, with a price range going from 0 to 100. The RSI chart can display data that you would not be able to see on the typical price chart, with examples of these including trend lines and double tops/bottoms.
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What are Overbought and Oversold levels?
An important thing to understand when analyzing the RSI indicator is to know when an asset is being overbought, and when an asset is being oversold. The overbought readings and oversold readings you should look out for are different values than the other.
If assets are considered overbought, the RSI will usually show a level over 70. However, if oversold, the oversold levels will usually be 30 or below. When the RSI line goes over 70 or under 30, these are typically either a buy signal or a sell signal respectively.
When the market is bullish, you can expect it to land somewhere between 40 and 90, with 40 to 50 serving as support. On the other hand, if the market is bearish, it tends to fall somewhere in the range of 10 to 60, while there is resistance in the range of 50 to 60.
By taking advantage of these, you may be able to make out like a thief, though such an outcome is never guaranteed when dealing with stocks and technical trading systems. Regardless, being able to understand how to read an RSI chart is a potential method of possibly lowering the potential risk of loss.
What are Failure Swings?
Failure swings refer to periods in the market where it experiences trend reversals. Trend reversals refer to the process of existing market trends changing to a new trend. As these trends change, you may find that you may break even, win big, or lose hard.
Failure swings were also devised by Wilder in his 1978 book, and they occur when the price line deviates from the RSI line. A failure swing that occurs while the RSI indicator is above 70 or below 30 is very indicative that a market reversal is afoot.
A failure swing occurs due to either prices failing to set new highs or meet new lows in an uptrend or downtrend, respectively. There are two terms relating to it: the Failure swing top and the failure swing bottom.
A failure swing top occurs as a result of the stock price going higher while the RSI is failing to reach a higher high, falling below the recent fail point. A top swing is indicative of a short position. Meanwhile, a failure swing bottom occurs as a result of the stock price going lower while the RSI is failing to reach a lower low, rising over the recent fail point.
By having a solid understanding of the relative strength index and using a strong technical analysis, you can do a world of good to help predict when such an event is likely to occur.
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Calculating RSI: How these calculations can be used to Understand Price Movements
Technical analysis is a valuable tool for those trying to wrap their heads around the RSI chart. Calculating RSI is itself not a complicated process, as it can be broken down into three units:
- Relative strength (RS)
- Average Gain
- Average Loss
Basically, it can be calculated by doing the following formula:
RSI = 100 – (100 / [1 + {14-Day Average Gain / 14-Day Average Loss}])
The 14 days portion of the RSI calculation is based on the default span of time included in Wilder’s book. Despite that default value, however, the 14-day value is not the only one with merit. There are also the nine-day RSI and the 25-day RSI, both of which have become more popular in recent years.
If you want to learn more about how best to calculate RSI, I would strongly recommend that you refer to Wilder’s book. It can give you a much more in-depth explanation than what I can in what time I have. In general, I recommend reading in detail about this subject, as it can provide significant benefits to your trading strategies.
What is the difference between RSI and relative strength?
Despite the fact that RSI stands for relative strength index, RSI and relative strength are not the same things. RSI refers to changes that occur in the price momentum of a single security’s price, whereas relative strength is used to compare the price movement of two or more securities.
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What is the difference between a Bullish divergence and a Bearish divergence?
When trading in the stock market, it’s important to have a full understanding of the different terminologies that come into play. Otherwise, you may not be able to meaningfully participate in technical trading systems.
If you haven’t already, two terms that you should acquaint yourself with are bullish and bearish, and these terms are in direct contrast with one another, though they are not necessarily incompatible terms.
The terms bullish and bearish are thought to be based on the methods bulls and bears fight, which are distinct from one another. Much like how a bull market is comparatively high, so too does a bull lift its victim high into the air with its horns. Similarly, just like how a bear market is on the downswing, an actual bear will have no trouble swinging you down to the ground.
Even among the separate classes of divergences, there are differing levels of divergences that you need to consider when weighing the risks. For both a bull market and a bear market, there are different classes of divergences.
Class B and Class C divergences are not entirely worth worrying about, as they tend to be somewhat unstable and unpredictable. However, a Class A divergence is the best atmosphere to trade in.
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What is a Bullish Divergence?
A bullish divergence occurs when assets on the price chart fall to a new low, even as the RSI oscillator is failing to reach a new low. In that kind of situation, it may be indicative that a downtrend is coming to an end. So, if you purchased an asset during the downtrend, a trend reversal may turn out to earn you a pretty penny.
Even if a certain asset is rather bearish at the time, the market itself may still be a bull market, so long as the price in the stock exchange is showing a rising bullish momentum on the relative strength index.
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What is a Bearish Divergence?
In truth, a bearish divergence – also known as a bearish signal – is often accompanied by a bullish attitude in the market. However, in such a market, it can get a little hairy (no pun intended). You see, when you are in a bearish market, you can experience a lot of risks.
Now, granted, the stock market is going to be a risky endeavor even if it is not currently bearish. But when you are in a bearish market, the risk only becomes that much greater.
A bearish divergence may signal potential downtrends in the market during a period when prices are rallying to new highs despite the RSI indicator not reaching new highs. Rather than there being anything that’s driving the market higher, the price chart is showing a rise simply because of inertia.
Now, if you’re wondering what is generally considered to be the signs of a bear market, it’s typically indicated by a drop in the market of at least 20 percent. However, just because the market dropped by 20 percent does not necessarily mean that it is entering a bearish market. For example, if it is only a short-term drop, this is likely just a price correction more than anything.
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Understanding RSI Divergence Classes
As discussed above, there are three classes for both types of divergences: A, B, and C. Below, I will detail the difference between these classes in each.
Bearish classes
Class A divergence
In a class A bearish divergence, the prices have risen to a new high, but the oscillator is showing a lower high than the high that has been previously shown on a previous rally. When a class A bearish divergence occurs, it is usually indicative of a reversal towards a downtrend, and a particularly significant one at that.
Class B divergence
Next up, we have the class B divergence, which comes about when prices experience a double top. A double top occurs when a price chart shows an increase twice, with a dip preceding, in between, and after. However, in such a divergence, the RSI indicator will show a weaker increase in the second “hill.”
Class C divergence
Finally, you have the class C divergence, wherein the price chart shows that prices are rising to a new high, but the relative strength index indicator stops at the level it reached in a previous rally. This is indicative of a stagnant market.
Bullish classes
Class A Divergence
A class A divergence occurs when the price chart shows that prices have hit a new low while the oscillator is reaching a higher bottom than it reached in its previous decline. If ever there was a good signal for a sharp rally, a class A divergence of this type is definitely one of the best you could ask for.
Class B Divergence
A class B divergence occurs when prices trace a double bottom on top of the oscillator tracing a higher second bottom.
Class C Divergence
Finally, a class C divergence occurs when prices fall to a new low at the same time as the relative strength index indicator is tracing a double bottom. Much like with bearish, a bullish class C divergence is a sign of a stagnating market.
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How to determine the Momentum of the Market
Divergences are a useful momentum indicator for people trying to better understand how the winds are blowing with the market. They can speak to overbought or oversold conditions, the trend direction, the price momentum, and more.
These divergences can help you understand when momentum will change, but just as important is that you be able to anticipate the speed by which a momentum shift is about to be approached. Thus, you need to be able to calculate how fast it may approach, which may be a little tricky.
One of the best indicators you could ask for to calculate how quickly the market is moving is called the rate of change. The rate of change works by comparing the current closing prices to the closing prices a certain number of days ago.
The calculations used to determine the momentum of the market is fairly similar to the one used to calculate speed. Basically, if today’s price is higher than it was when compared to a certain date, this serves as a high momentum indicator. Meanwhile, if it is lower, that suggests low momentum. Finally, if there is no change, then the momentum remains the same.
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Is the relative strength index a reliable method of buying and selling in trending markets?
It is one thing to know how the relative strength index works, but it is another thing entirely to figure out whether following it is good in trending markets. The truth is, RSI readings are not foolproof, particularly since the ultimate results are not guaranteed. In fact, RSI signals from your RSI readings during strong upward and downward trends may prove to be false.
There are also limitations that you need to keep in mind when you are attempting to utilize the RSI indicator. RSI benefits from having a long-term trend that the data can conform to. If you don’t have that, the RSI chart may not be as accurate as it could be.
At times, a true reversal signal will be difficult to distinguish from a false alarm, which – for obvious reasons – is a serious issue if you are relying too hard on it to determine what you do in the stock market and technical analysis.
There may even be circumstances wherein the relative strength index is not able to properly reflect momentum on the oscillator, instead sticking with its current overbought or oversold levels despite momentum having gone in either direction. As a result, you are best served by utilizing the RSI indicator in a trading range (also known as an oscillating market) rather than a trending market.
Are there better technical analysis tools to use than the relative strength index?
While traders often use an RSI reading to help understand how the market’s direction is going, that does not necessarily mean it is the only tool that can do this or even the best one for the job. With that being said, are there other tools or better tools?
Well, another common tool is called the money flow index, or MFI, which is a more volume-focused version of the relative strength index. An advantage that RSI has over MFI is that it tends to be a more reliable tool to analyze bear and bull markets. Meanwhile, MFI is best suited to spot reversals and false signals.
In addition to MFI is also the moving average convergence divergence (MACD). This is another momentum oscillator that traders use to indicate the direction the wind seems to be blowing. MACD calculations are determined using 26-point exponential moving averages (EMA) from the 12-period EMA. This results in the creation of a MACD line.
A nine-day total of EMA is overlaid over the MACD line. Traders either may purchase the security when the MACD crosses its signal line. However, if the MACD line falls below the signal line, you can instead choose to sell or short.
A key difference between a MACD line and an RSI indicator is the focus of these two tools. Where the RSI indicator is focused on measuring price change momentum as they relate to both recent price highs and lows. Meanwhile, the MACD line is a measurement between two EMAs.
They both serve as a measure of an asset’s momentum; however, they look at different relevant areas to determine how much momentum the asset has. In fact, the methods they use may wind up contradicting the other tool.
So, when trying to pick the ideal tool, be sure to weigh what you need the tool to do.
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