What is the Relative Strength Index?
The Relative Strength index (RSI) is a momentum oscillator used to track the strength or weakness of the S&P 500 or other index or asset. Based on the closing prices, and typically using a 14 day timeframe, the RSI will signal to a trader if they can trust the price trend. This oscillator measures the magnitude and velocity of directional price movement. 70 is considered the high level and 30 is considered the low level. If the RSI hits 80 or 20 as the high and low, the momentum is considered to be very strong, and if the RSI hits 90 or 10 as the high and low, the momentum is considered to be extremely strong.
RSI Helps Signify Overbought and Oversold Levels
The numbers 70 and 30 signify overbought and oversold levels, respectively. When a price is making higher highs and the RSI begins to hit 70, the stock is considered overbought and this presents a selling signal. Likewise, when the price is making lower lows and the RSI heads lower down towards 30, the stock is considered oversold, and this presents a buying signal.
RSI as Confirmation for Trend Reversals
When tracking a trend, traders typically check several indicators against each other. The Relative Strength Index can be used alone to check against the price to determine if the price highs or lows are valid. If the RSI swings above 70 then drops back down, that is considered a signal for a trend reversal from bullish to bearish. Similarly, if the RSI swings below 30 then back up, that is considered a signal for a trend reversal from bearish to bullish. However, if the price continues to make higher highs, and the RSI does not, that is potentially a hidden divergence and signals a false bull run. And if the price continues to make lower lows but the RSI does not, that is considered a hidden divergence as well and signals a false bear run.
How to Use RSI to Trade
Traders typically use the relative strength index along with another indicator to bolster their confidence in the signals they receive. RSI works well with the moving average convergence divergence indicator or MACD, as well as candlestick patterns.
Photo Credits: http://en.wikipedia.org/wiki/File:RSIwiki.gif
Coming soon is an explanation of how to use the MACD to find hidden divergence.