RSI, unlike what the name may suggest, is an indicator of a security’s strength to itself. It does not compare a security with an Index or a security with another security. The formula for RSI is:
D - Average of downward price change
How is Relative Strength Index Used ?
RSI is an indicator that follows price and ranges between 0 and 100.
The most popularly used Relative Strength Index is the 14-day RSI. Other regularly used ones are 9-day and 25-day RSIs. The lower the number of days used for calculation, the shorter the time frame it can be used for. It also tends to be more volatile. The practical application of RSI needs some experience as it cannot be applied directly.
The RSI usually ranges between 30 and 70 in an ideal market. The tops and bottoms are usually formed before the underlying price. In a bull market, this range may be 40 to 80. Similarly, in a bear market, it may range from 20-60.
RSI very often displays chart-like pattern such as double top, inverted head and shoulders and so on even though they may not show on the actual price charts. One can identify such patterns to trade successfully.
This is where the Relative Strength Index surpasses a previous high (peak) or falls below a recent low (trough).
Support and Resistance
Supports and Resistances are sometimes more clearly on the RSI chart than on the price charts.
When the price makes a new high but the RSI does not do so, it is called a divergence on the RSI chart. Eventually, prices correct and move in the direction of the RSI. Thus, divergences are indications of impending reversal. When the RSI turns and falls below its most recent trough, a confirmation of the reversal is obtained and a “failure swing” is said to have occurred.