Relative Strength Index (RSI)

he Relative Strength Index (RSI) is one of the more popular technical analysis tools; it is an oscillator that measures current price strength in relation to previous prices. The RSI can be a versatile tool, it might be used to:

• Generate potential buy and sell signals 
• Show overbought and oversold conditions 
• Confirm price movement 
• Warn of potential price reversals through divergences 

The chart below of eBay (EBAY) shows some potential buy and sell signals:

 

RSI Potential Buy Signal

A trader might buy when the RSI crosses above the oversold line (30).

RSI Potential Sell Signal

A trader might sell when the RSI crosses below the overbought line (70).

Varying the time period of the Relative Strength Index might increase or decrease the number of buy and sell signals. In the chart below of Gold, two RSI time periods are shown, 14-day (default) and 5-day. Notice how in this example, decreasing the time period made the RSI more volatile, increasing the number of buy and sell signals substantially.

There is another way a trader might interpret Relative Strength Index buy and sell signals. This, and how to interpret RSI divergences, is all contained on the next page.

RSI Alternative Possible Buy and Sell Signals and Divergences

I.RSI Divergences

An alternative way that the Relative Strength Index (RSI) may give buy and sell signals is given below:

• A trader might buy when price and the Relative Strength Index are both rising and the RSI crosses above the 50 Line. 
• Similarly, a trader might sell when the price and the RSI are both falling and the RSI crosses below the 50 Line. 

An example of this potential methodology for buying and selling based on 50 Line crosses is given below in the chart of Wal-Mart (WMT):(Source: onlinetradingconcepts.com)

For another method for using the RSI indicator for potential buy and sell signals, see: Stochastic RSI, which combines both the popular Stochastics indicator and the Relative Strength Index. 

II. RSI Confirmations & Divergences

Another usage for the Relative Strength Index is to attempt to confirm price moves and attempt to forewarn of potential price reversals through RSI Divergences.

The chart below of the E-mini Nasdaq 100 Futures contract shows the RSI confirming price action and warning of future price reversals:

Low #1 to Low #2 

The E-mini Nasdaq 100 Futures contract's price made a substantial move from Low #1 to Low #2. The RSI confirmed this move, which may have helped a trader have confidence jumping on board the price move higher.

The break of trendline of the e-mini future was also confirmed by the trendline break of the Relative Strength Index, suggesting that the price move may likely be over.

Low #3 to Low #4

A bullish divergence was registered between Low #3 and Low #4. The e-mini Nasdaq 100 future made lower lows, but the RSI failed to confirm this price move, only making equal lows. A trader might see this RSI divergence and begin taking profits from their shortsells.

High #1 to High #2

A bearish divergence occured when the e-mini futures contract made a higher high and the RSI made a lower high. This bearish divergence suggested that prices could be reversing trend shortly. A trader might consider reducing their long position, or even completely selling out of their long position.

(Source: onlinetradingconcepts.com)