RSI

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The RSI (Relative Strength Index) is one of the most popular momentum oscillators in technical analysis use today; it was introduced in a 1978 book by J. Welles Wilder.

The RSI compares the magnitude of recent gains to the magnitude of recent losses. Results are represented in a range between 0 and 100. The RSI is calculated by means of the following formula:

RSI = 100 - 100 / (1 + RS)

Where RS is the ratio between the average gains and average losses over a specified period:

RS = (Average Gains) / (Average Losses)

The author of the RSI recommends a standard setting of 14 bars to calculate the average gain and loss; however, it is important to remember that the Average Gain and the Average Loss do not represent true averages! Total gains (losses) are always divided by the specified number of time periods 14 in this case, instead of the number of gaining (losing) periods.

70 and 30 are the most commonly used RSI levels for a market considered to be "overbought" or "oversold", respectively. Basically, the RSI is a measure of the strength of a recent trend:

• RSI is considered strongly bullish if the 14-day RSI exceeds 70 this means the security has trended up strongly over the past 14 days. Some would consider the security to be overbought at these levels, and a potential selling point might thus be reached when the RSI exceeds 70;
• If the 14-day RSI is between 50 and 70, the security has moved up over the past 14 days; however, the uptrend has not been very pronounced;
• If the 14-day RSI is between 30 and 50, the security has moved down over the past 14 days; however, the downtrend has not been very strong;
• If the 14-day RSI is below 30, the security has trended strongly lower over the past 14 days and the RSI is considered strongly bearish. Some would consider the security to be oversold at these levels, and an RSI reading below 30 might thus mark a potential buying point.

As is the case with many price indicators, the RSI may generate false signals at times. A market will not always turn when the RSI exceeds 70 or when it trades below 30. When we see volume surges in conjunction with a strong market advance or decline, the probability of a reversal becomes much higher.

Chart 1: Dow Jones Industrials (^DJI) - RSI (12)

The following is a simple trading system based on combining the RSI with our volume indicators:

1. When the RSI rises above 70, sell on a significant volume surge.
   As a general rule, volume surges that appear during strong index advances - (i.e., when the RSI > 70) - indicate potential downside reversals;
2. Buy on a significant volume surge when the RSI drops below 30.
3. As a rule general, volume surges that appear during strong index declines (i.e., when the RSI < 30) - indicate potential upside reversals;
   3. Ignore volume surges that appear when the RSI remains between 30 and 70. Under such circumstances, market reactions may be short-lived.

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