The Relative Strength Index (RSI) is a momentum based oscillator which measures both the speed (Velocity) and the change (Magnitude) of directional price movements. Momentum based oscillators essentially measure the level by which a security’s price has changed over a set period of time within a set of parameters
The RSI is one of the most popular technical indicators used today. The RSI indicator can be applied to nearly all markets, but it is most commonly applied to larger and more liquid markets such as forex, stocks, and commodities.
The RSI holds the ability to visually highlight both the current and historical strengths and weaknesses of a particular market. Interpretations and predictions are made through the identification of certain signals such as divergences, centreline crossovers and failure swings and chart patterns such as double tops and bottoms and trend lines.
The RSI oscillates between the values of 0 and 100 and is calculated using the equation:
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) )
RSI = 100 – 100/ (1+RS)
RS = Average gain / Average loss
(Average gain or loss = Difference between periodic closing values)
Inherently being momentum based, the closer the RSI is to 0, the weaker the momentum is for price movements and as the RSI becomes closer to 100 this instead indicates a period of stronger momentum. “Momentum” essentially refers to the acceleration by which the price of the security changes. The RSI is calculated by using the last 14 periods of price action, which is the default setting. The number of periods can be either lowered to increase sensitivity or raised in order to decrease sensitivity. The lower the number of periods, the more likely RSI will reach overbought or oversold levels since the oscillator becomes more sensitive.
Overbought refers to a period when the security’s price has seen consistent price hikes with high momentum up to the point such that a selling opportunity is evident. Oversold refers to a period when the security’s price has dropped rapidly but also with low momentum such that a purchasing opportunity has become evident.
Depending on the security itself, reversals are generally more likely once they reach the overbought or oversold levels. The inspected security is generally considered to be overbought when its RSI is higher than 70 or alternatively oversold when RSI is below 30. RSI higher than 70 will also indicate overvaluation of the currency whilst RSI than 30 additionally indicates an undervaluation.
When RSI moves above the horizontal 30 reference level, this is an indicator for bullishness, whilst when RSI deviates below the horizontal 70 reference level, this alternatively indicates bearishness. In a bull market, the RSI tends to remain between 40 and 90, with 40 to 50 acting as support and in a bear market the RSI generally stays between 10 and 60, with 50 to 60 acting as resistance.
However such indicators for oversold and overbought or bullish and bearish market tendencies are generalised and do not accurately represent every single security in the market, in which case customisations/changes can be made. For example a security which has been consistently hovering at the oversold level of 20 for a few months may have to have to have its oversold level customised to instead be at 10. Additionally, during strong uptrends overbought markets can stay at the overbought level for quite a long time.
Overbought and oversold levels can also be adjusted such as when using 2 period RSI instead of 14.
When looking for short-term overbought/oversold readings or short term buy-sell signals, a shorter look-back period will be used whilst when looking to capture the general trend of the security, a longer look-back period will be used.
As seen here 2 period RSI chart is a lot more volatile and choppy as opposed to a 25 period RSI chart. The 2 period RSI chart reaches overbought and oversold levels much more frequently. Short-term traders will use 2-period RSI to look for overbought readings above 80 and oversold readings below 20.
RSI sensitivity is also influenced by the underlying security. An index, like the S&P 500, is generally less volatile than individual stocks such as Amazon.
10-period RSI for Amazon will usually be more volatile than 10-period RSI for the S&P 500.
Signals: RSI Divergence
RSI Divergence provide buy and sell signals, with divergences categorised into bullish (Selling opportunity, short) or bearish (Buying opportunity, long) divergence signals. A divergence is essentially when the movement of the price is opposite to the movement of the technical indicator, in this case the RSI, leading to an impending reversal in price.
Bullish divergences begin occur the price of the security has been falling whilst RSI is in the oversold territory but on an increasing trajectory (Momentum increasing). The divergence will require the RSI to penetrate past the oversold territory at some point and maintain a consistent increase, whilst the price of the security has fallen to a new low, causing the security’s price to reverse (Now on a bullish trajectory). Generally the price low will occur at the exact same time as when the RSI penetrates the oversold level, but this is not always the case. As a result of this divergence, once the low has been reached, both RSI and Price will now be increasing simultaneously (Bullish), signalling the time to make a long position on the security.
Bullish divergences can simply be summarised as when, prices makes a new low (Decreases in price up to a certain point from which the price will have to reverse and increase) and RSI makes a higher low (In the oversold area but breaks past this level to sustain a consistent increase in higher RSI).
Bearish Divergences essentially work by the same principle, but instead result in short signals. Bearish divergences will occur when the price has followed a sustained increase, whilst RSI within the overbought territory follows a declining trajectory (Momentum decreasing). The divergence will require the RSI to penetrate through the overbought level at some point, with price again reaching an extreme point, this time instead a new high. The new high will be followed by a reversal in price movement (Now on a bearish trajectory) with the RSI declining at the same time. Price highs will generally coincide with the RSI penetrating the overbought level, marking the beginning of the bearish trend and the need to go short.
Bearish divergences can simply be summarised as when, prices makes a new high (Increases in price up to a certain point from which the price will have to reverse and decrease) and RSI makes a lower high (In the overbought area but breaks past this level to sustain a consistent decrease in reduced RSI).
Signals: Failure Swings (Also called swing rejections)
Failure swings are another type of signal predicting price reversals. The failure swing methodology relies solely on the RSI value without requiring reference to the security’s price action. Swings are categorised into either top failure swings which indicate bearishness or bottom failure swings which indicate bullishness.
Top failure swings/bearish failure swings occur when price makes a higher high but a peak in the RSI fails to surpass a previous peak in the uptrend. RSI will fall below the recent swing low (fail point), triggering a signal to go short. During the first high, RSI will surpass the 70 overbought level whilst during the second high, the indicator makes a swing high below the 70 overbought level.
Bottom failure swings occur when price makes a lower low. The second trough of the RSI however is higher than the first trough and it will rise above the recent swing high (fail point), triggering a signal to go long. During the first low, RSI will go below the 30 oversold level whilst during the second low, the indicator makes a swing low above the 30 oversold level.
Bottom/Bullish Failure Swing
- RSI drops below 30 (Oversold Level).
- RSI bounces back above 30 (To Fail Point)
- RSI pulls back but holds above 30 (Above Oversold Level)
- RSI surpasses its previous high (Surpasses Fail Point)
Top/Bearish Failure Swing
- RSI rises above 70 (Overbought Level)
- RSI drops back below 70 (To Fail Point)
- RSI rises slightly but remains below 70 (Below Overbought Level)
- RSI drops lower than its previous low (Below Fail Point)
Limitations of the RSI Indicator
- Similar to most technical indicators, RSI signals are most reliable when the security is following a long-term trend.
- True reversal signals rarely occur and are difficult to separate from false alarms. False alarms include false positives whereby bullish crossovers which indicate price hikes are instead followed by a sudden decline and false negatives whereby there is bearish crossover but the security instead accelerates upwards.
- Traders must take into consideration that RSI is momentum based so while the security’s price momentum remains strong the RSI can stay in overbought or oversold territory for long periods of time. Therefore accommodations will have to be made. RSI is most reliable in an oscillating market whereby the price is consistently alternating between bullish and bearish periods.
- As per any other indicator, RSI is one of many and should be compared with others before assuming certain directions of the market. Theories regarding signal analysis have still yet to be consensually agreed on with Wilder (The original developed of RSI) believing that a bullish divergence was a sign that the market would soon be on the rise, while Cardwell (A student who developed upon Wilder’s interpretations) believed that such a divergence was instead just a slight price correction on the continued road of a downward trend.
Stochastic Oscillator: Overview
The term ‘”stochastic” in trading simply refers to the relationship between a security’s current closing price in relation to a predetermined price range over a period of time. A stochastic oscillator is a technical, momentum based indicator which follows this notion by essentially creating a range between the lowest and highest price values during a set period of time and then expressing the current closing price as a percentage of this range, with 0% indicating the bottom of the range and 100% indicating the upper limits of the range. The oscillator is therefore bounded between the values of 0 and 100.
Sensitivity of the oscillator to market movements may be adjusted by changing the length of the time period or by taking a moving average of results. Similar to the RSI, the oscillator will produce both overbought and oversold results with readings over 80 traditionally considered to be in the overbought range, whilst readings under 20 are considered oversold. In a market trending upwards, prices will close near the high, and in a market trending downwards, prices will close near the low
The Stochastic Oscillator chart generally has of two lines each representing:
- The value of the stochastic oscillator for each session %K
- The three-day simple moving average (SMA) %D
The formula for the stochastic oscillator is:
%K=(C – L14/H14 – L14) × 100
C = Most recent closing price
L14 = Lowest price traded in the previous 14 trading sessions (Assuming 14 day period)
H14 = Highest price traded in the previous 14 trading sessions (Assuming 14 day period)
%K = Current value of the stochastic indicator
%D = 3-day SMA of %K
The simple moving average (SMA) is another type of technical indicator calculated as the summation of recent closing prices divided by the number of periods. The Simple moving average indicator is useful for determining whether an asset price will continue or reverse a bull or bear trend.
The intersection or divergence of these two lines may signal a future reversal. Divergence reversal signals operate the same way RSI would. For example for a bullish divergence there may be current bearish price trend which reaches a new low whilst the oscillator improves to a higher low. This may indicate that bears are exhausting their momentum and a bullish reversal is imminent.
Difference between RSI and Stochastic Oscillator
The stochastic oscillator is founded on the assumption that closing prices should close near the same direction as the current price movement and works best in consistent trading ranges. RSI instead measures the velocity of price movements and was designed to measure the speed of price movements, while In general, the RSI is more useful during trending markets, and stochastics more so in sideways or choppy markets.
Limitations of the Stochastic Oscillator
- The stochastic oscillator has been known to produce false signals, especially during volatile market conditions which can happen quite regularly. One way to tackle this is to take the price trend as a filter, whereby signals are only taken if they are in the same direction as the trend.
Stochastic RSI: Overview
The Stochastic RSI a technical indicator which provides a stochastic based calculation and interpretation to the RSI. It is momentum based and combines the properties of two other momentum based indicators: The Stochastic oscillator and the Relative strength index. Since it is derived from the RSI it is often considered an “Indicator of an indicator”.
Stochastic RSI is calculated as:
Stochastic RSI = (Current RSI – Lowest RSI) / (Highest RSI – Lowest RSI)
Usually 14 periods is used as the range for the lowest and highest RSI readings. The Stochastic RSI chart will generally be displayed in conjunction with a 3 period simple moving average of stochastic RSI.
The RSI indicator is one step away from price movements since it is a first derivative of price Meanwhile, the stochastic RSI is derived from RSI itself and is therefore two steps away from price movements. Because of this, the stochastic RSI chart will may often be out of sync with the security’s market price in real time and is this also make it a lot more sensitive. This increased sensitivity allows for quicker insights into price movements since the RSI may often fail to hit the extreme values around the 80 and 20 mark.
The primary purpose of the Stochastic RSI is for identifying overbought and oversold conditions and crossovers. Similar to the stochastic oscillator, stochastic RSI has overbought conditions at 80, oversold conditions at 20 and values between 0 and 100 (Sometimes measured between 0 and 1 instead) essentially measuring the percentage value of the price in relation to a given price range over a certain period. Generally when the Stochastic RSI crosses above the oversold level it is a signal to go long whereas when the Stochastic RSI crosses below the overbought level it is a signal to sell.
Crosses at the 50 level are another signal whereby, when Stochastic RSI crosses above the 50 level then buy and when Stochastic RSI crosses below 50 then sell. A moving average applied over a period of 5 days can be used a short term signal, with a moving average above 50 signalling bullishness whilst a moving average below 50 signals bearishness.
Similar to RSI the principle of failure swings can be similarly applied for stochastic RSI
As evident here, the stochastic RSI reaches the extreme values (Oversold or overbought values) a lot more often than the RSI does.
Limitations of Stochastic RSI
- Stochastic RSI tends to be highly volatile, rapidly moving from high overbought values to low oversold values. To create better short term trend identification and remove volatility it may be helpful to lengthen the calculation period and/or apply a moving average calculation.
- Stochastic RSI dramatically increases the signal count as opposed to RSI. There will be more overbought/oversold readings, more centreline crosses, more good signals and more bad signals. However this speed comes at a price. It is important to use Stochastic RSI with other forms of technical analysis to verify conclusions gained from stochastic RSI signals such as gaps, support and resistance breaks, and price patterns.
Written by Nathan Chua – 9/06/2019