The Relative Strength Index (RSI), developed by J. Wellis Wilder is very useful and is a popular momentum oscillator. The RSI is used to compare the magnitude of a stock’s recent gains to the magnitude of its recent losses. It then turns that information into a number that ranges from 0 to 100. It takes a single parameter, the number of time periods to use in the calculation. Usually 14-periods are recommended.
Calculation :
100
RSI = 100 - --------
1 + RS
RS = Average Gain / Average Loss
Average Gain = [(previous Average Gain) x 13 + current Gain] / 14
First Average Gain = Total of Gains during past 14 periods / 14
Average Loss = [(previous Average Loss) x 13 + current Loss] / 14
First Average Loss = Total of Losses during past 14 periods / 14
Note: "Losses" are reported as positive values.
INTERPRETATION :
Overbought/Oversold
Wilder recommended using 70 and 30 and overbought and oversold levels respectively. Generally, if the RSI rises above 30 it is considered bullish for the underlying stock. Conversely, if the RSI falls below 70, it is a bearish signal. Some traders identify the long-term trend and then use extreme readings for entry points. If the long-term trend is bullish, then oversold readings could mark potential entry points.
Divergences
Buy and sell signals can also be generated by looking for positive and negative divergences between the RSI and the underlying stock. For example, consider a falling stock whose RSI rises from a low point of (for example) 15 back up to say, 55. Because of how the RSI is constructed, the underlying stock will often reverse its direction soon after such a divergence. As in that example, divergences that occur after an overbought or oversold reading usually provide more reliable signals.
Centerline Crossover
The centerline for RSI is 50. Readings above and below can give the indicator a bullish or bearish tilt. On the whole, a reading above 50 indicates that average gains are higher than average losses and a reading below 50 indicates that losses are winning the battle. Some traders look for a move above 50 to confirm bullish signals or a move below 50 to confirm bearish signals.
