RSI was introduced by Welles Wilder in the late 1970’s. Wilder observed that you should initiate the trade when the momentum indicator changes direction only when the average upmove is greater than the average downmove over a given number of days, or the inverse for a sell signal – when the average momentum is relatively higher or lower.
RSI uses averages over several days (usually 14) rather than price points. The formula for RSI is:
1. Calculate the average upmove over a number of days divided by the average downmove of the same time period.
2. Divide that ratio into 100.
3. Subtract that number from 100.
The resulting number will be in the range of 0 to 100.
Interpretation of RSI
RSI is plotted on a scale of 0 to 100. Movements above 70 are considered to indicate possible overbought conditions and movements under 30 indicate possible oversold conditions.
Movement through the 70 and 30 levels are used to generate signals – when RSI crosses back under 70 this can be interpreted as a sell signal, crossing back above 30 generating a buy signal.
The default setting for RSI is 14 days, but this can be shortened to 5 or 7 days for short term traders. The shorter the time period used the more pronounced the swings of the RSI line.
Divergence between RSI and price when RSI is above 70 or below 30 is a powerful overbought/oversold indicator, suggesting possible price reversal.
The 50 level corresponds with the zero line in other oscillators such as CCI and can act as support and resistance and also generate buy or sell signals when the RSI line goes through it in the direction of the trend.
Trendline analysis can be used on the RSI line itself.
RSI Failure Swings
Wilder outlined a trade set up called failure swings.
– A top failure swing occurs when a peak over 70 fails to exceed a prior peak in an uptrend and is followed by a break of a previous trough
– A bottom failure swing occurs when RSI is in a downtrend under the 30 level, fails to break a prior low and then advances higher than a previous peak.
The RSI moving into overbought or oversold territory is not strength enough to initiate a position in the opposite direction of price movement. Rather, it should be a sign that you should not add to your positions in the direction of the trend. To initiate a position in the opposite direction you are better off looking for further confirmation – such as those outlined in Wilders RSI Failure Swings.
Also, bear in mind that RSI is limited by the fact that it is taking the high low swings from a set time period. For example if you have an uptrend that last for 90 days and the RSI is set to use 14 days as the base range, the signals will be more valid to a short term swing trader than a longer term trader.