The Relative Strength Index (RSI) is a popular technical indicator used by stock market investors to determine the momentum of a bid and ask for shares or indices. It measures the size of a stock’s recent gains against its recent losses and is scaled from 0 to 100. The volatility of RSI values increases with a shorter time frame used, and convergence and divergence between the RSI and the stock’s price change are important when using the RSI to determine whether to buy or sell.
A type of trading system technical indicator called an oscillator, stock market investors use relative strength to determine the upward or downward momentum of a bid and ask for shares or indices. Relative strength utility/popularity is based on the premise that it will peak or bottom before the stock or index price does. The Relative Strength Index (RSI) measures the size, or magnitude, of a stock’s recent gains against the magnitude of its recent losses. The resulting RSI values are scaled and plotted from 0 to 100, with 30 typically serving as the lower threshold indicating a stock is oversold and 70 the upper threshold indicating a stock is overbought. The concept of relative strength and RSI was invented by Welles Wilder, who described them in New Concepts in Technical Trading Systems, which he himself published in 1978.
Relative Strength is an exponential moving average of “up” and “down” price movements based on the closing prices of each day in the RSI calculation period. The ratio of the exponential moving average of the days “up” – that is, the numerator – and the days “down” – the denominator – in the period indicates the RSI. The RSI is set to 100 if there are zero “down” days in the period.
The volatility of RSI values increases with a shorter time frame used. A 7-day RSI, for example, will be more volatile than a 21-day RSI. The prices of a stock in the last 7 and 14 days are typical periods used to calculate the RSI.
The convergence and divergence between the RSI of a stock and its coincident price change are important when using the RSI to determine whether to buy or sell a stock or index. Convergence is a situation where the price of a stock and its RSI go up together. This is considered a bullish trading signal indicating that the demand for shares is growing; in other words, this suggests that investors are hoarding the shares.
Divergence, on the other hand, is a situation where a rising or consistently high RSI coincides with a downward movement in the share price. This is considered a bearish sign, indicating that prices are likely to fall. Typically occurring after a stock has risen in price, divergence as an indication of “distribution”—that is, those who have kept the stock on track are now booking profits and exiting by selling the stock to new buyers.
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