Introduction to Understanding the Relative Strength Indicator (RSI)

Picture Courtesy Of Smart Forex Trading

Trading financial instruments is a constant process of speculation. Knowing the right time to buy or sell an instrument can greatly aid in ensuring that you rake in profits from trading. This can be done through the use of tools that aid in predicting the future movement of the price of a stock. Some of the most used indicators measure the momentum in the price movement. This means how strong the stock is moving up or down. A strong movement in a particular direction may indicate a likely future trend but it may also show when a stock is overbought or oversold.

To measure momentum, technical traders use RSI as a key indicator. RSI stands for Relative Strength Index and is represented as a value in the range between 0 to 100. Values above 50 show that an upward movement is likely to occur, while values below 50 indicate a downward momentum. The further the distance from 50 the stronger the momentum in either direction. Values above 70 or below 30 show that the momentum is so strong indicating that the market is oversold or overbought. Often in extreme conditions, the price will move in the opposite directions briefly to alleviate the oversold/overbought condition

RSI is measured through how often the market closes up vs closing down and by what margin. It is calculated through the use of a relatively simple formula:

RSI = 100- 100/(1+RS)

It is easy to note that relative strength is therefore measured by taking the average size of all the up moves over a particular period divided by the average size of all the down moves over the same time.

One powerful indication of a price reversal is RSI divergence. Using RSI in terms of catching divergence makes the indicator one of the most popular and profitable indicators out there. It occurs when RSI does not confirm higher highs or lower lows. For example, the price has made a new low but RSI has not. The chart above shows RSI divergence and how it can signal a selling opportunity (beware using it to short stocks).

If you are interested in learning more about technical indicators take a look at The Art Of Mastering Japanese Candlesticks as well as my favorite two stock chart technical indicators.

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