ASX Charting Course

Chapter 27

Relative strength Indicator

The relative strength indicator is an oscillating type of indicator that attempts to quantify price momentum. It’s a front weighted, price velocity, ratio indicator developed by J. Welles Wilder in 1978. It should not be confused with other relative strength indicators that measure the strength of a single stock or commodity against the broader market. Instead this indicator measures the recent strength of a commodity relative to its past strength.

RSI = 100 – [100 / (1 + RS)]

RS = the ratio of the exponentially smoothed moving average of n-period gains divided by the absolute value of the exponentially smoothed moving average of n-period losses.

A simple expression of RS = Average price change for up days / Average price change for down days.

The indicator is bounded by the values 0-100 and can be used as an overbought / oversold indicator. The market is said to be overbought when the indicator is above the 70-80 line and oversold when below the 20-30 region. Different charting packages will use different parameters to determine the overbought / oversold lines, but these lines will always fall within the bands 20-30 and 70-80. The buy or sell trigger is activated when price reaches these lines, on a closing basis. A sell signal is activated when the indicator exceeds the overbought line and a buy signal is generated when the indicator hits the oversold line.

Divergence in the RSI indicator with respect to price will often indicate that a turn in price is imminent. Similarly failure swings, like in the example below, provide an indication that the market may be ready to turn. This occurs when the market makes a new peak, in this case a low, but the indicator fails to make a new peak low.

The latest signal generated, a sell signal, comes almost as the result of true divergence. Firstly, the indicator has just recently reached the 70 line indicating the market is near a top. A sell signal is generated when price eclipses that first high again, but the indicator fails to reach the same level as before.

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