The RSI was developed by J. Welles Wilder, Jr. and presented in his 1978 book, New Concepts in Technical Trading Systems. We're only going to cover the main points here. A reading of the original work by Wilder himself is recommended for a more in-depth treatment. Because this particular oscillator is so popular among traders, we'll use it to demonstrate most of the principles of oscil­lator analysis.
As Wilder points out, one of the two major problems in constructing a momentum line (using price differences) is the erratic movement often caused by sharp changes in the values being dropped off. A sharp advance or a decline 10 days ago (in the case of a 10 day momentum line) can cause sudden shifts in
the momentum line even if the current prices show little change. Some smoothing is therefore necessary to minimize these distor­tions. The second problem is that there is the need for a constant range for comparison purposes. The RSI formula not only pro­vides the necessary smoothing, but also solves the latter problem by creating a constant vertical range of 0 to 100.
The term "relative strength," incidentally, is a misnomer and often causes confusion among those more familiar with that term as it is used in stock market analysis. Relative strength generally means a ratio line comparing two different entities. A ratio of a stock or industry group to the S&P 500 Index is one way of gauging the relative strength of different stocks or indus­try groups against one objective benchmark. We'll show you later in the book how useful relative strength or ratio analysis can be. Wilder's Relative Strength Index doesn't really measure the relative strength between different entities and, in that sense, the name is somewhat misleading. The RSI, however, does solve the problem of erratic movement and the need for a constant upper and lower boundary. The actual formula is calculated as follows:
RSI = 100 100
1 + RS
Average of x days' up closes RS = Average of x days' down closes
Fourteen days are used in the calculation; 14 weeks are used for weekly charts. To find the average up value, add the total points gained on up days during the 14 days and divide that total by 14. To find the average down value, add the total number of points lost during the down days and divide that total by 14. Relative strength (RS) is then determined by dividing the up aver­age by the down average. That RS value is then inserted into the formula for RSI. The number of days can be varied by simply changing the value of x.
Wilder originally employed a 14 day period. The shorter the time period, the more sensitive the oscillator becomes and the wider its amplitude. RSI works best when its fluctuations reach the upper
and lower extremes. Therefore, if the user is trading on a very short term basis and wants the oscillator swings to be more pronounced, the time period can be shortened. The time period is lengthened to make the oscillator smoother and narrower in amplitude. The amplitude in the 9 day oscillator is therefore greater than the orig­inal 14 day. While 9 and 14 day spans are the most common val­ues used, technicians experiment with other periods. Some use shorter lengths, such as 5 or 7 days, to increase the volatility of the RSI line. Others use 21 or 28 days to smooth out the RSI signals.
Interpreting RSI
RSI is plotted on a vertical scale of 0 to 100. Movements above 70 are considered overbought, while an oversold condition would be a move under 30. Because of shifting that takes place in bull and bear markets, the 80 level usually becomes the over­bought level in bull markets and the 20 level the oversold level in bear markets."Failure swings," as Wilder calls them, occur when the RSI is above 70 or under 30. A top failure swing occurs when a peak in the RSI (over 70) fails to exceed a previous peak in an uptrend, fol­lowed by a downside break of a previous trough. A bottom failure swing occurs when the RSI is in a downtrend (under 30), fails to set a new low, and then proceeds to exceed a previous peak Divergence between the RSI and the price line, when the RSI is above 70 or below 30, is a serious warning that should be heeded. Wilder himself considers divergence "the single most indicative characteristic of the Relative Strength Index" [Wilder,
p. 70].Trendline analysis can be employed to detect changes in the trend of the RSI. Moving averages can also be used for the same purpose In my own personal experience with the RSI oscillator, its greatest value lies in failure swings or divergences that occur when the RSI is over 70 or under 30. Let's clarify another impor­tant point on the use of oscillators. Any strong trend, either up or down, usually produces an extreme oscillator reading before too long. In such cases, claims that a market is overbought or oversold are usually premature and can lead to an early exit from a profitable trend. In strong uptrends, overbought markets can stay overbought for some time. Just because the oscillator has moved into the upper region is not reason enough to liqui­date a long position (or, even worse, short into the strong uptrend).
The first move into the overbought or oversold region is usually just a warning. The signal to pay close attention to is the second move by the oscillator into the danger zone. If the second move fails to confirm the price move into new highs or new lows (forming a double top or bottom on the oscillator), a possible divergence exists. At that point, some defensive action can be taken to protect existing positions. If the oscillator moves in the opposite direction, breaking a previous high or low, then a diver­gence or failure swing is confirmed.
The 50 level is the RSI midpoint value, and will often act as support during pullbacks and resistance during bounces. Some traders treat RSI crossings above and below the 50 level as buying and selling signals respectively.