What is Relative Strength Index (RSI): Definition
Developed by technical analysis pioneer, Welles Wilder, the Relative Strength Index (RSI) is a versatile indicator that measures the speed and change of price movement. The RSI is can be used to:
- Determine when an instrument is overbought or oversold
- Confirm trend direction
- Identify potential entry and exit points
- Forecast possible market reversals
RSI is displayed as a momentum oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100.
See the RSI in action in this quick video tutorial:
Calculating the Relative Strength Index (RSI) Formula
Understanding how the RSI is calculated can help traders properly incorporate the indicator into a technical analysis mix. In essence, the RSI offers a measurement of how well an instrument is performing by comparing the strength of up vs down days using the following formula:
RSI = 100 – 100 / (1+RS)
RS: Average gains/average losses within a user-defined period of time.
How to Use RSI Indicators for Trading: Buy and Sell Signals
The RSI in NinjaTrader consists of two oscillators, the results of the RSI formula (Blue) and the Average of the RSI (Yellow). Additionally, an upper and lower value line is plotted at 70 and 30, respectively.
The default look-back period for the RSI in NinjaTrader is 14, and the Average defaults to a 3 period. While Wilder recommends a 14 look back period in his 1978 book, New Concepts in Technical Trading Systems, traders may consider adjusting this parameter depending on the instrument traded and to what degree of sensitivity is sought in the behavior of the indicator. Lowering the look-back period will increase sensitivity while raising it will decrease its sensitivity.
RSI Crossover Strategy
Both the RSI and the Average oscillate between the ranges of 1 and 100, and it’s most commonly used to identify overbought and oversold conditions denoted by 70 & 30 crossovers.
A value of 70 is considered overbought & a reversal to the downside is probable. RSI readings over 70 shows a strong run of an instrument recording higher highs, which may not be sustainable. Conversely, a value of 30 is considered oversold & a directional shift to the upside has potential.
Below is a daily chart of the May 2018 Crude Oil contract showcasing the behavior of the RSI in relation to price action from mid-December to late February. As the RSI dances around the 70 line, it is a good indication the instrument is in overbought territory. Note that the CL did not automatically reverse into a bearish slide as soon as the 70 thresholds was breached. It remained bullish for nearly a month before reversing course.
In mid-February, the RSI almost reaches the 30 line, a good signal that it is reaching the point of oversold. Another important aspect to note is that while the RSI it did not cross the 30 line, the instrument still reversed. This behavior reiterates the importance of using the RSI in conjunction with other complementary indicators to avoid false signals & to potentially adjust the parameters of the indicator to synch with the behavior of the instrument.
RSI Divergence Explained
Bearish divergence occurs when the instrument price is rising, yet the RSI is falling. Bullish divergence is just the opposite, the price is falling, but the RSI is on the rise. Traders should heed warning when this occurs as a correction may be underway because the momentum of the buying or selling pressure is weakening.
Below is an example of Bearish divergence on the E-Mini S&P daily chart.
As demonstrated, there are multiple approaches to use the RSI to gain market insight. However, as with a number of trading indicators, the RSI has its limitations. Technical analysts agree that the RSI should be used as a confirmation tool in conjunction with other indicators that provide insight on market behavior.
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