Oscillators

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Relative Strength Index(RSI)

First, in this thread, I will provide the original definition of RSI, which Wells Wilder Jr. presented in his book “New Concepts in Technical Trading Systems,” published in 1978.

"The RELATIVE STRENGTH INDEX, RSI, is a tool which can add a new dimension to chart interpretation when plotted in conjunction with a daily bar chart.
Some of these interpretative factors are:

TOPS and BOTTOMS are indicated when the RSI goes above 70 or drops below 30.
CHART FORMATIONS which often show up graphically on the RSI may not be apparent on the bar chart.
FAILURE SWINGS above 70 or below 30 on the RSI scale are strong indications of market reversals.
SUPPORT and RESISTANCE often show up clearly on the RSI before becoming apparent on the bar chart.
DIVERGENCE between the RSI and price action on the chart is a very strong indication that a market turning point is imminent.

Before taking up the equation for calculating the Relative Strength Index, let's examine briefly the momentum concept upon which the RSI is based.

The Momentum Oscillator Concept

One of the most useful tools employed by many technicians is the momentum oscillator. The momentum oscillator measures the velocity of directional price movement. When the price moves up very rapidly, at some point it is considered to be overbought; when it moves down very rapidly, at some point it is considered to be oversold. In either case, a reaction or reversal is imminent. The slope of the momentum oscillator is directly proportional to the velocity of the move. The distance traveled up or down by the momentum oscillator is proportional to the magnitude of the move.

The momentum oscillator is usually characterized by a line on a chart drawn in two dimensions. The 'Y' axis (vertical) represents magnitude or distance the indicator moves; the 'X' axis (horizontal) represents time. The momentum oscillator drawn in this manner is characterized by the fact that it moves very rapidly at market turning points and tends to slow down as the market continues the directional move.

Suppose we are using the close price to calculate the oscillator and the price is moving up daily by exactly the same increment from close to close. At some point, the oscillator begins to flatten out and eventually becomes a horizontal line. When this occurs, if the price begins to level out, the oscillator will begin to descend.

Let's look at this concept using a simple oscillator expressed in terms of the price today minus the price 'x' number of days ago.
In this example, we will use the price today minus the price ten days ago. The oscillator is measured from a zero line. If the price ten days ago were higher than the price today, then the oscillator value is minus; conversely, if today's price were higher than the price ten days ago, then the oscillator value is plus.

The easiest way to illustrate the interaction between price movement and oscillator movement is to take a straight line-price relationship and plot the oscillator points based on this relationship.

RSI pic 6_1.png

In Fig. 6.1, we begin on Day 10 when the close price is 48.50. The price ten days ago, on Day 1, is 50.75. Utilizing a ten day oscillator, we take today's price of 48.50, subtract the price ten days ago, 50.75, and the result, -2.25, is the oscillator value. This oscillator value of -2.25 is plotted below the zero line. By following this procedure for each day, we develop the oscillator curve.

The oscillator curve developed in this hypothetical situation is very interesting. As the price moves down by the same increment each day between Days 10 and 14, the oscillator curve is a horizontal line. On Day 15, the price turns up by 25 points yet the oscillator turns up by 50 points.
The oscillator is increasing twice as fast as the price. The oscillator continues this rate of movement until Day 23 when its value becomes a constant although the price continues to move up at the same rate.

On Day 29, another very interesting thing happens. The price levels out at 51.00, yet the oscillator begins to go down, If the price continues to move horizontally, the oscillator will continue to descend until the tenth day at which time both the oscillator and the price will be moving horizontally.

Note the interaction of the oscillator curve and the price curve. The oscillator appears to be one step ahead of the price; the reason being that the oscillator, in effect, is measuring the rate of change of price movement. Between Days 14 and 23, the oscillator shows that the price rate of change is very fast because the direction of the price is changing from down to up. Once the price of ten days ago has bottomed out and star-ted up, then the rate of change slows down because the increments of change are measured in one direction only.

The oscillator can be an excellent technical tool for the trader who understands its inherent characteristics; however, there are three problems encountered in developing a meaningful oscillator.

The first problem is erratic movement within the general oscillator configuration. As an example of this, using a ten day oscillator, suppose that ten days ago the price moved limit down from the previous day. Now, suppose that today, the price closed the same as yesterday. When we subtract the price ten days ago from the price today, we will get an erroneously high value for the oscillator today. To overcome this problem, there must be some way to dampen or smooth out the extreme points used to calculate the oscillator.

The second problem characteristic of oscillators is the scale to use for the 'Y' axis. In other words, how high is high and how low is low? The scale will also change with each commodity being charted. To overcome this problem, there must be some common denominator to apply to all commodities so the amplitude of the oscillator is relative and meaningful.

The third problem is the necessity of having to keep up with enormous amounts of data. This is the least of the three problems; however, it can become burdensome to the trader who is follow-ing several commodities with an oscillator technique.

The solution to these three problems is incorporated in the indicator which we will call THE RELATIVE STRENGTH INDEX.

The Relative Strength Index Equation

The equation for the Relative Strength Index, RSI, is:

RSI = 100 - 100/(1 + RS)

RS = Average of 14 day's closes UP / Average of 14 day's closes DOWN


For the first calculation of the Relative Strength Index, RSI, we need the previous 14 day's close prices. From then on, we need only the previous day's data. The initial RSI is
calculated as follows:
(1) Obtain the sum of the UP closes for the previous 14 days and divide this sum by 14. This is the average UP close.
(2) Obtain the sum of the DOWN closes for the previous 14 days and divide this sum by 14. This is the average DOWN close.
(3) Divide the average UP close by the average DOWN close. This is the Relative Strength (RS).
(4) Add 1.00 to the RS.
(5) Divide the result obtained in Step 4 Into 100.
(6) Subtract the result obtained in Step 5 from 100. This is the first RSI.

From this point on, it is only necessary to use the previous average UP close and the previous average DOWN close in the calculation of the next RSI.
This procedure, which incorporates the dampening or smoothing factor into the equation, is as follows:
(1) To obtain the next average UP close: Multiply the previous average UP close by 13, add to this amount today's UP close (if any) and divide
the total by 14.
(2) To obtain the next average DOWN close: Multiply the previous average DOWN close by 13, add to this amount today's DOWN close (if any) and divide
the total by 14.
Steps (3), (4), (5) and (6) are the same as for the initial RSI.

Now that we know how to obtain the RELATIVE STRENGTH INDEX number for each day, let's discuss briefly the peculiarities of the RSI in light of the three problems inherent to most oscillators:
(1) Erroneous erratic movement is eliminated by the averaging technique. However, the RSI is amply responsive to price movement because an increase of
the average close UP is automatically coordinated with a decrease in the average close DOWN and vice versa.
(2) The question of 'how high is high and how low is low' is answered because the RSI value must always fall between 0 and 100. Therefore, the daily
momentum of any number of commodities can be measured on the same scale for comparison to each other and to previous highs and lows within the
same commodity. The most active commodities are those in which the RSI is showing the greatest vertical movement - either up or down.
(3) The problem of having to keep up with mountains of previous data is also solved. After calculating the initial RSI, only the previous day's data is
required for the next calculation.

Learning to use this index is a lot like learning to read a chart. The more a trader studies the interaction between chart movement and the Relative Strength Index, the more revealing the RSI will become. If used properly, the RSI can be a very valuable tool in interpreting chart movement. The RSI points are plotted daily on a bar chart and when connected, form the RSI line.

Now let's look at the different things this in-dex can tell us; first, the Index itself indicates:
(1) Tops and Bottoms: These are indicated when the Index goes above 70 or below 30. The Index will usually top out or bottom out before the actual
market top or bottom, giving an indication that a reversal or at least a significant reaction is imminent.
(2) Chart Formations: The Index will display graphic chart formations which may not be obvious on a corresponding bar chart. For instance, head
and shoulders tops or bottoms, pennants or triangles often show up on the Index to indicate breakouts and buy and sell points.
(3) Failure Swings: Failure swings above 70 or below 30 are very strong indications of a market reversal. (See Fig. 6.3 and Fig. 6.4).

RSI pic 6_3-4-1.png

Second, the Index, in conjunction with the bar chart, defines these interactions:
(4) Support and Resistance: Areas of sup- port and resistance often show up clearly on the Index before becoming apparent on the bar chart. In
fact, support and resistance lines drawn using Index points are often analogous to trend lines drawn using bar chart points.
(5) Divergence: Divergence between price action and the RSI is a very strong indicator of a market turning point. Divergence oc-curs when the RSI is
increasing and the price movement is either flat or decreasing. Conversely, divergence occurs when the RSI is decreasing and price movement is either flat
or increasing. (Note on the June Silver chart, Fig. 6.5, that there was divergence between the bar chart and the RSI at every major turning point.)

RSI pic 6_5.png

In view of these five interpretive factors of the RSI, let's examine the bar chart of June 1978 Chicago Silver.
(1) Tops and bottoms: The major bottom of August 15 was accompanied by an RSI value below 30. During the next few days, a turning point was
indicated by divergence between the RSI and price action. The major top of November 9 was preceded by an RSI value above 70. The top made on January
24 was preceded by an RSI value of less than 70. This would indicate that this top is less significant than the previous one and that either a higher top is in
the making or that the long-term up trend is running out of steam.
(2) Chart Formation: Note the pennant formed on the RSI line during October that is not evident on the bar chart. A breakout of this triangle indicates
an intermediate move in the direction of the breakout. Note also the long-term pennant with the large number of supporting points on the RSI line. A
significant breakout of this triangle should be indicative of the next long-term trend.
(3) Failure Swings: Failure swings made by this Index are most significant after an RSI high in the area of 70 or low in the area of 30. Note that when
the RSI reached 70, the immediate down swing carried to 58. It is not unusual for the following up swing to be composed of several small swings as long
as the high and low of the main swing are not penetrated. When the low point of 58 was penetrated, the failure swing was completed. On the low of
August 15, the failure swing carried up to 41 on the RSI scale. After several small down swings, this point was penetrated on the up side on August 26.
(4) Support and Resistance: Trend lines on the bar chart often show up as support lines on the RSI. Notice the support lines made by the low swing
points during October and part of November could be used to confirm trend lines drawn on the chart. Depending upon who is drawing the trend line, a
breaking of the trend line could have occurred on November 4; however, this was not confirmed on the support line drawn on the RSI.
(5) Divergence: Although divergence does not occur at every turning point, it does occur at most significant turning points. When divergence begins
to show up after a good directional move, this is a very strong indication that a turning point is near. Divergence is the single most indicative characteristic
of the Relative Strength Index. Note that the top made on November 9 was Indicated by an RSI value above 70 and divergence. It was confirmed by the
failure swing, breaking out of the pennant formation and breaking the support line.

The Relative Strength Index, used in conjunction with a bar chart, can provide a new dimension of interpretation for the chart reader. No single tool, method or system is going to produce the right answers 100% of the time. A successful trader utilizes several different kinds of input into his decisions. Often the problem is in narrowing this input down to two or three things that work best for him. In this context, the Relative Strength Index can be a valuable input into this decision-making process.