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Wednesday, December 19, 2007

TA: Relative Strength Index (RSI)

The Relative Strength Index (RSI) is an extremely useful and popular momentum oscillator. The RSI compares the magnitude of a stock's recent gains to the magnitude of its recent losses and turns that information into a number that ranges from 0 to 100.

Calculation












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.

Divergence
Buy and sell signals can also be generated by looking for positive and negative divergence 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.


Example:


The DJI example shows a number of extreme readings as well as a negative divergence. In Mar-2007, RSI reached oversold for a brief moment to mark the low around 25. The next extreme reading (overbought) occurred after April and continue sustain above level 70 until June. Then it was moving sideway after a large advance that peaked in July-2007. The next positive divergence reading occurred in August. for another brief moment and marked the low around 35. In early of September, RSI moved back above 50 and into overbought territory in October. A negative divergence formed in first week of October and marked the high in the upper fifties. Then it moved down to level 30.

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