The Relative Strength Index was developed by J. Welles Wilder Jr. and introduced in his book, New Concepts in Technical Trading Systems in 1978. He described and interpreted the indicator and later the work of Brown and Cardwell developed new interpretations and concepts using the RSI indicator. Even dating back to 1978 the indicator proved to be very useful technical analysis tool and grew in popularity over time.
RSI is a momentum indicator that measures the speed of price movements and gives the signals of the change of the price direction. It is used to identify overbought and oversold areas, to spot divergencies and price reversals. It is displayed as an oscillator moving in a range between 0 to 100. Chart patterns can also be identified on the RSI which might not be on the original price chart.
RSI is simply calculated usually with 14 days period.
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]
More positive closes increase the value of RSI. More losses decrease the value of RSI. RSI is measured between 0 and 100. Values above 70 are regarded as the overbought area. Values below 30 are regarded as the oversold area. Bonds could be changed in order to get more, or less, sensitive moves.
RSI is used to identify divergencies. If the original price chart form lower low and RSI creates higher low, it indicates a bullish divergence and the change of price direction. Break above the oversold area indicates trader can enter in a new, long position. Conversely, a bearish divergence when RSI from an overbought position records a lower high while an original chart shows a higher high of the price.
Finally, Cardwell identified positive and negative price reversals in the RSI. When price corrects an uptrend and records a higher low, while RSI hit lower low it forms a positive reversal. This lower low is usually somewhere between 30 and 50. A negative reversal occurs when a correction in a downtrend records a lower high, but RSI hit a higher high just below overbought levels, in the 50-70 area. Cardwell concluded that positive reversals only happen in uptrends while negative reversals only occur in downtrends, and therefore their existence confirms the trend. Reversals are the opposite of divergences.
Traders should keep in mind that strong price momentum can continue, and RSI could stay in the overbought/oversold areas for a longer time. Moreover, true reversal signals are rare and instead could be just a false alarm.