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Benjamin Schmitz

How does relative strength index work?

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The relative strength index, or RSI, is a momentum indicator that tracks the speed and change of price movements. It is an oscillator that moves between 0 and 100, where traditionally a score of 70 indicates a stock is overbought and a score of 30 indicates the asset is oversold. Relative strength index works because it measures an equity’s recent performance against its historical price to identify trends. Before you can understand RSI as a technical trading tool, you need to understand how oscillators work. Oscillators are favored by traders because they are leading indicators that help predict a trend change that hasn’t yet been demonstrated by market movement. When a market trades within a given range, the oscillator smooths out moving averages by following price fluctuations between two values. Oscillators are most useful when the market is trading horizontally within a narrow range as opposed to raging bullish or bearish markets. Oscillators only reach 0 or 100 in strongly trending markets. The math behind the RSI is complex; it is a two-step process that looks at the percentage of loss or gain over a time period, typically 14 days, and then smooths out those values. Many traders argue that a stock is overbought at a reading well below 70, and oversold and values well above 30. In other words, in a generally bearish market, RSI stays between 20 and 60, with resistance occurring around 50, suggesting that a stock reaches overbought territory closer to 60. In a generally bullish market, RSI moves between 40 and 90, with resistance kicking in as it approaches 50, suggesting a stock is in oversold territory when the RSI breaks 60. RSI has its limitations as an indicator, however. It is most reliable when it confirms a long-term trend as opposed to predicting a reversal. Remember, it is a momentum indicator, and as long as momentum remains strong, either upward or downward, RSI could stay in overbought or oversold territory for long periods of time. Using RSI with MACD gives a better overall technical picture of the market. MACD is also a momentum indicator, but it shows the relationship between the two moving averages to give insight into the strength of the momentum. RSI measures price differences in relation to previous highs and lows. As such, the two indicators are often in contradiction. In other words, RSI may indicate the market is overextended, but MACD indicates increasing momentum. MACD crossovers are buy/sell signals; when the red EMA line crosses the black MACD line, that’s a sell signal and when MACD crosses the red EMA, it’s a buy signal. In the chart above, you see in the box to the left that sell signals are present both in RSI and MACD in early September. The stock was overbought, indicating a reversal, which was confirmed with MACD crossover a few days later. To the right, the indicators appear to be in contradiction, with MACD suggesting the breakout was gathering momentum and RSI suggesting the market was overextended. The 15-day moving average is acting as support. Again, as a trader, you shouldn’t rely on a single oscillator or indicator, but instead, pick a few to combine that suit your trading style and use them to confirm signals.

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