This indicator (aka Relative Strength Index) aims at
establishing a reference scale independently from the stock prices levels
themselves. As the RSI has boundaries (0 and 100), it then becomes very easy to
determine overbought and oversold areas. Thus, the RSI is one of the most
commonly used counter-trend indicators.
It is based
on the average of rises and drops of a stock, with the formula :
RSI = 100 – [100 / (1 + RS)]
where RS represents the average of up closes divided by the
average of down closes on the considered period.
Consequently, the shorter the studied period, the more volatile
the RSI. Depending on trading habits, longer or shorter lengths can thus be used
but the most common length is 14 days.
On a graph,
lines can be drawn at 30 and 70. A crossing down of 30 indicates that the
market is oversold while a crossing up of 70 indicates that the
market is overbought.
Just as for the MACD,
it is possible to smooth signs given by the RSI by forming two RSI on two
different periods. Then, a crossing up of the long-term RSI by the short-term
RSI constitutes a buying signal while a crossing down of the long-term RSI by
the short-term RSI constitutes a selling signal.
The principle of divergences is also applicable to the
RSI, and is more easily applicable than on the MACD, as overbought and oversold
areas can legitimately be drawn.
Finally, just as
on stock prices themselves, supports and resistances can appear,
especially when nearing the neutrality zone (near 50).
