## Finance Strategy System

RSI oscillator (Relative Strength Index) | Essential Tutorial

## Introduction

RSI Oscillator has a history that begins from a long distance; it was 1978 when a particular book of technical analysis appeared, “New concepts in technical trading systems” this text would change the way of studying the financial markets.

You remember Welles Wilder, a former mechanical engineer who left his job in the early 1970s to engage in financial markets and their analysis.

He understood early on something that later became fundamental in the analysis of financial markets: he realized that the way of doing analysis had to be changed by constructing mathematical indicators, but tried to describe what the analyst observes visually and what the experience of financial markets teaches to those who are experts in the field.

The result of Welles Wilder’s research a tool is invented that had a high diffusion and is known by the full name of Relative Strength Index that turns the role of an excellent momentum indicator let’s find out how RSI works and so that it can quickly become a valuable resource for investment in financial markets.

## How the RSI Oscillator works

The basic concept on which RSI was built is straightforward: it is based on the fact that when the price is stable then the higher the upwards than the downwards closures,  quite the opposite happens when the cost is in a phase of weakness, the downwards closures at that point will undoubtedly be higher than the upwards closures.

So we are talking about an indicator very similar to the stochastic one, as we mentioned before. Still, here the market strength is calculated in a much simpler way than the stochastic one for which the comparison is made between the closing level and the minimum range of a specified period.

RSI, on the other hand, is based on whether upward closures weigh heavier than downward closures.

Of the two directions, the ones that weigh the most indicate the prevailing direction of the market.

However, when we talk about the averages of positive and negative closures, we will not go to calculate the moving averages of closing sessions with positive or negative closure. Still, in reality, it is a matter of adding the positive price differences of the last 14 meetings and dividing this sum by 14 months ago by the negative price differences.

The RSI oscillator varies between two values of 0 and 100.  The SRI will be 0 when in the last 14 sessions, there has been no positive closure, while it will be 100 when there has been no final positive price change in the previous 14 meetings.

Welles Wilder has also taken care to provide us with guidance on how to read and interpret data from RSI. The levels considered necessary by the same scholar are the area above 70 points and below 30 points.

Those who take advantage of the RSI oscillator and usually indicate these two particular areas as overbought when we are above 70 points, and oversold when we are below 30 points.

So let’s take a closer look at what is meant by overbought and oversold, although there is no trace of these terms in Wilder’s book and studies.

Hypercurchased: this is called the phase in which the indicators themselves reach their peaks; these conditions generally occur when the price itself has pushed, according to mathematical calculations, towards its ascending limits and therefore is destined to reverse its course.

Hypervended: the same is true for the overselling phase; here too, the RSI has reached more or less its maximum, indicating that the price has reached a downward limit area, and the market could soon generate a bullish reaction.

RSI is a handy indicator for investors and is well understood precisely by looking at the definitions we have given of overbought and oversold.

When the price is brought to these limit areas, the operational indications offered by the market analysis with the RSI become clear with unparalleled clarity, let us, therefore, try to understand what types of positions can be opened by observing the RSI oscillator.

Entering the long market: by assessing the situation well, you can open a buying position on the asset when the RSI shows a case of overselling, that is, you must observe that the indicator line falls below the value of 30.

Enter the short market: in turn, a downward reversal could occur if the market is in the limit area of​ ​overbought.

It is unlikely that the market will be able to sustain those rhythms, and therefore the reversal could occur soon, at a time when the RSI line is above the value of 70.

RSI is an indicator that can provide very reliable trading signals, but as always, the advice is to combine the data it contains with those of other indicators.

There are many equally easy to read indicators that can make the pair excellent with RSI; we are talking, for example, about Mobile Media, an indicator of which we have already highlighted the qualities and qualities, as well as how to use it in another article.

This indicator, like all others, can in some cases generate false signals because being perfect for indicating momentum changes does not always suggest trend changes through them, which is why many traders tend to use RSI as a simple aid to graphical analysis, but if exploited with the right awareness when reading a graph can provide valuable indications and allow you to promptly intuit the most given moments to enter or even leave a position.

The Relative Strength Index (RSI), conceived by J.W.Wilder and published in the book New Concepts in Technical Trading Systems, is one of the most used technical oscillators by analysts and traders.

This oscillator measures average upward pressure over a specific period, typically 14 days. The upward pressure is then compared with the average downward pressure of the same period.

The formula used to calculate is the following:

RSI = 100 – (100 / (1 + RS))

where RS is the average of the upward closures of the last x days/average of the downward closures of the last x days.

It is the ratio between how much the market has increased on average and how much it has decreased on average over the last x days.

Thanks to this report, we have an immediate idea of whether the upward pressure was higher than the downward pressure or whether it was the latter that prevailed.

For example, if during the last 14 sessions the market, when it rose, did so by an average of 1.00%, while what fell suffered an average decline of 0.50%, the RSI oscillator will register an upward pressure double that of the downward one.

The RSI is usually calculated in 14 periods, but its length can be shortened or extended to adapt it to the type of operation to be used.

As with all other indicators, it should be noted that:

• By reducing the reference period, the oscillator becomes very reactive but can provide false operating indications.
• By extending the time horizon, signals are more reliable, but they are sent somewhat later than price dynamics.

### RSI Period and Time Frame

Daily, many operators use a 5-period RSI to obtain timely signals and a 15-month RSI to get confirmatory signals.

The oscillator, which moves in a range between 0 and 100 points, has two particularly exciting areas:

The area of overbought, between 70 and 100 points, the achievement of which by RSI indicates that prices have picked up rapidly Indicates that the market has created an excessive imbalance between the strength of buyers and that of sellers.

The situation of overbought shows that in recent sessions, the upward pressure has increased significantly. It indicates that prices have increased sharply, but in the very short term, it will be difficult for them to continue to rise.

Buyers could reduce the intensity of their purchases, and, at the same time, there could be an increase in downward pressure.

A correction or a break in lateral consolidation could start on the market.

### OverSold Area

The oversold area, between 30 and 0 points, the achievement of which by RSI indicates that prices have fallen sharply. It suggests that the market has created an excessive imbalance between the strength of sellers and that of buyers.

The situation of OverBougth shows that in recent sessions, the upward pressure has increased significantly. So prices that have fallen sharply, but in the very short term, it is steep for them to continue to fall.

Sellers could reduce the intensity of their sales, and at the same time, there could be an increase in upward pressure.

A quick technical rebound or a short side stage of consolidation could start on the market.

During solid directional phases, therefore, RSI will move within its overbought or oversold area. This may confirm the soundness of the trend on the market.

For this reason, you should not close long positions or open short positions just because the oscillator is inside its overbought area.

Likewise, you should not open long positions or close any short positions just because the oscillator is within its overselling area.

### Consolidation Phases

RSI can be useful when the market moves within side consolidation phases. With prices fluctuating in the trading-range.

The oscillator can signal the achievement of the minima and maxima that occur in this side channel.

However, the most exciting signals provided by RSI relate to the indicator’s ability to draw upward/downward divergences from price developments.

I

n particular:

RSI provides a negative signal when it weakens after reaching its overbought area.

Later the oscillator, with the prices pushing further upwards, tries a new elongation but remains below its previous maximum.

In this way, a negative divergence is drawn, created by the increasing maxima drawn by the prices and the decreasing peaks drawn by the oscillator.

### RSI Signals

RSI provides a positive signal when, after reaching its overselling area, it makes a quick recovery.

Later the oscillator, with prices still falling, weakens but remains above its previous low.

In this way, a positive divergence is drawn, created by decreasing minima drawn by prices and increasing minima drawn by the oscillator.

The cyclical behavior of RSI By analyzing the cyclical behavior of RSI, some recurrent situations can be identified. In particular:

When prices are within a stable positive trend, it is common for RSI, after exceeding its equilibrium line, to move quickly within its overbought area.

This behavior highlights both an apparent strengthening of upward pressure and the fact that prices may have risen too rapidly.

This situation may not last too long: in the future, buyers’ strength will tend to diminish, and there may also be a strengthening of downward pressure.

It is the phase in which the typical downward divergences between price and oscillator trends can occur and in which the preconditions for a physiological correction by the market are created.

When prices are within a stable negative trend, it is common for RSI, after falling below its equilibrium line, to fall rapidly within its overselling area.

This behavior highlights both an apparent strengthening of upward pressure and the fact that prices may have risen too rapidly.

This situation may not last too long, as the strength of the sellers will tend to diminish at a later stage, and there may be an increase in upward pressure.

It is the phase in which upward divergences can occur between the price trend and that of the oscillator and which creates the conditions for a physiological technical rebound.

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