Technical Toolbox: Relative Strength Indicator (RSI)
RSI is a momentum oscillator that helps traders determine if a security is overbought or oversold.
RSI was developed and published by J. Welles Wilder in his 1978 book "New Concepts in Technical Trading Systems". The RSI seeks to measure the rate of upward or downward change in the price of a security over a measured timeframe, most commonly 14 days. RSI oscillates between zero and 100. If a stock were to rise each day over the 14 day period, that would give a value of 100. If it were to fall in each of those days, it would give a value of 0. A stock that was essentially flat over the period would yield a value of 50.
In common practice, RSI gives values falling mostly between 20 and 80. Wilder posited that values over 70 indicated a state of being overbought and values under 30 indicated a state of being oversold. An example of a stock having moved into overbought territory is Leucadia (NYSE:LUK) which had rallied quite consistently since the beginning of the year:
RSI first moved above 70 back in January, suggesting the stock was becoming overbought back then. Traders must be careful using this oscillator and not interpret that a rise above 70 means an immediate correction. Note that LUK remained overbought for the next three weeks before finally correcting.
RSI can also depict a stock that has become oversold as seen with the Market Vectors Junior Gold Miners (NYSE:GDXJ):
In addition to the absolute level of RSI, Wilder looked for divergences between his oscillator and the price action of the stock it measured. We see that divergence in GDXJ where at the end of February the price action for GDXJ continues downward while RSI is moving up. This divergence is thought to signal the end of a trend.
RSI, like most technical indicators, is best used in conjunction with a number of indicators, and not strictly on its own. The absolute level of RSI can inform a trader that a trend has become extended and may be nearing a time when it will revert to the mean. When RSI diverges from the price action, this becomes further evidence the trend looks about to change.