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Relative Strength Index (RSI)

Background: Relative Strength Index (RSI) is one of several innovative technical indicators introduced by J. Welles Wilder Jr. in his 1978 book, New Concepts in Technical Trading Systems. It was developed as another means of comparing the strength of price changes, putting up and down days based on the close into two separate categories. In that regard, it has some similarities to the Directional Movement Index.

There are really two different uses for the term "relative strength." The first suggests the strength of one market vs. another or how a market or market sector compares to some benchmark. The second usage refers to the strength of a price move for one period against the strength of a move for another period and in this usage serves as a measure of momentum.

Purpose: One of the problems in analyzing prices is that they sometimes make sharp, erratic moves that can distort the overall picture of strength or weakness for a market, especially when one of the older erratic moves drops out of the calculation. Wilder's RSI provides a smoothing effect for these changes and places the current strength of a market within a 0 to 100 scale.

Relative Strength takes the average of the up closes for a given time period and divides that up average by the average of down closes during that period. Typically, 14 periods are used for RSI, but the number can be more or less, depending on the sensitivity of the index desired. That can vary to fit the time frame the user is trading.

By plotting RSI on an index scale of 0 to 100, a move to above 70 can suggest an overbought situation that might lead to a downturn or a move to below 30 can suggest an oversold condition that might lead to an upturn in prices. (Those thresholds can change to 80 in bullish markets or 20 in bearish markets.)

Basic signals: As with a number of other indicators, RSI is most effective when its readings are at the upper or lower extremes of the scale. When the RSI moves above 70 and then fails to move above a previous peak and falls through the downside of a previous dip, prices can be expected to move lower. On the other end of the spectrum, a bottom failure occurs when RSI drops below 30, then fails to set a new low and moves above a previous peak.

Several examples can be found on the chart below. The first is a buying situation on a bottom failure when the second low is not as low as the first low and RSI breaks out higher. The second is a signal for a selling opportunity when RSI tops 70, the second RSI high is below the first high and RSI drops below the RSI low. Of course, not every move above 70 or below 30 results in a great signal so any trading requires sound money management techniques.

As with other indicators, divergence between the direction of prices and the RSI line is also an important clue that RSI has detected an underlying change in market conditions and prices may be about to turn in the direction of the indicator, as the chart illustrates. These clues can be used in conjunction with traditional chart pattern or moving average analysis.

Pros/cons: RSI is one of the most popular indicators, but not every signal requires instant response. Traders should keep in mind that the first foray of RSI into overbought or oversold territory may be just a warning or an alert, with the second move into this area serving as the real point at which to take some type of trading action.

RSI is adaptable to various time frames for those who want to adjust the sensitivity of the indicator. It has also been the basis for other indicators building on the RSI concept.

Relative Strength Index RSI

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About the Author

Formerly Editor-in-Chief of Futures Magazine, Darrell has been writing about financial markets for more than 35 years and has become an acknowledged authority on derivative markets, technical analysis and various trading techniques.

Raised on a farm near the tiny southeastern Nebraska town of Virginia, Jobman graduated from Wartburg College in Iowa in 1963. He began his journalistic career as a sportswriter for the Waterloo (Iowa) Courier for several years before going into the Army. He served with the 82nd Airborne Division and as an infantry platoon leader with the Manchus in the 25th Infantry Division, including nine months in Vietnam in 1967-68, earning the Silver Star and Bronze Star.

After military service, Jobman returned to the Courier, where he became farm editor in early 1969. He was introduced to futures markets when he wrote a column about how speculators were ruining farm prices and was “corrected” by Merrill Oster. That led to writing assignments for Oster and then a full-time position in 1972, where Jobman participated in the founding of Professional Farmers of America and associated newsletters.

When Oster purchased Commodities Magazine in 1976, Jobman was named editor and later became editor-in-chief of Futures Magazine when the name was changed in 1983 during one of the biggest growth periods for new markets and new trading instruments in futures history. He was an editor at Futures until 1993, when he left to become an independent writer/consultant.

Since 1993, he has written, collaborated, edited or otherwise participated in the publication of about a dozen books on trading, including The Handbook on Technical Analysis. He has also written or edited articles for several publications and brokerage firms as well as trading courses and educational materials for Chicago Mercantile Exchange and Chicago Board of Trade. He also served as editorial director of CME Magazine.

Jobman and his wife, Lynda, live in Wisconsin, and spend a lot of time visiting with a daughter and three grandchildren also in Wisconsin, and a son and granddaughter in Florida.

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