Examining the Relative Strength Index

My personal favorite indicator is the relative strength index (RSI). The RSI compares the strength of a stock's up days against the strength of its down days, and RSI proponents believe that as a result, the RSI can cut through erratic changes and really confirm price movement. This index is considered a leading indicator because you can usually count on the direction of a security's RSI to change ahead of its price action.

The origin of overbought and oversold levels

You may be wondering how the overbought and oversold levels were established. Those benchmarks came from the mind of renowned technical analyst J. Welles Wilder, who introduced the RSI in his 1978 book New Concepts in Technical Trading Systems. In the book, Wilder recommends using 30 as an oversold level (an attractive area to buy) and 70 as an overbought level

(an area to exit or sell short). Look at Figure 11-9. The oversold level of 30 and overbought level of 70 are indicated with lines along the bottom of the chart to allow you to see when the level penetrates either of these significant levels. He also suggests using 14 as the standard number of price periods for calculating RSIs, which is the input used for the chart in Figure 11-9.

The RSI is classified as a momentum oscillator. The "momentum" in that term comes from the fact that as a security is in an up or downtrend, the RSI's trend should correspond. And it's an "oscillator" because RSIs fluctuate between 0 and 100 percent.

Another attractive feature of RSIs is they include levels that indicate when a security is considered overbought or oversold. When the security reaches one of these levels, a savvy trader should be on his toes, waiting for a corresponding change in the trend of the RSI, or even better, some sort of revealing bullish or bearish candlestick pattern that lets him know it's time to buy or sell.

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