Relative strength index (RSI)

The Relative Strength Index (RSI) is a momentum indicator that was developed by a fellow named J. Welles Wilder. Its calculation requires the average up move and down move over the last x periods (days on a daily chart). As a reminder, you have an up move whenever the close of the day is higher than the close of the day before (up day); same idea for the down move.

To get the RSI, you calculate the ratio of the average up move to the average down move, add 1, invert the result, multiply by 100 and finally subtract the number obtained from 100. By adding 1 to the ratio, you make sure the result is greater than 1. Inverting a number greater than 1 gets you a number between 0 and 1. You end up with an indicator that ranges from 0 to 100, in other words, an oscillator.

If the average up move is equal to the down move, the RSI is equal to 50. The greater the average up move (compared to the down move), the closer the RSI is to 100. Similarly, the greater the average down move (compared to the up move), the closer the RSI is to 0. When the RSI is above 70, the security is considered overbought, that is, everybody that wanted to buy has done so; it is a signal to sell. When the RSI goes below 30, the stock is seen as oversold; it is a buy opportunity.

Buy and sell signals can also be obtained from divergences between the RSI and the stock price. When the Relative Strength Index shows divergence with the stock price, it usually indicates that the current price trend is wearing off. For example, if the RSI dives down while the stock price is in an uptrend, it can be assumed the trend will end soon and that profit should be taken (sooner than later).