Relative Strength Index (RSI) is an oscillator developed by J. Welles Wilder, Jr. It is now included in most software packages. RSI measures the strength of any trading vehicle by monitoring changes in its closing prices. It is a leading or a coincident indicator-it is never a laggard.

The pattern of RSI peaks and valleys does not change in response to the width of its time window. Trading signals become more visible with shorter RSI, such as 7 or 9 days. Most traders use computers to calculate and plot RSI. Take these steps to calculate a 7-day RSI for any market:

•  Obtain closing prices for the past 7 days.

•  Find all days where the market closed higher than the day before and
add up the amounts of increases. Divide the sum by 7 to obtain the
average UP closing change.

•  Find all days when the market closed lower than the day before and
add up the amounts of declines. Divide the sum by 7 to obtain the
average DOWN closing change.

•  Divide the average UP closing change by the average DOWN closing
change to obtain Relative Strength (RS). Insert RS in the formula
above to arrive at RSI - Relative Strength Index.

•  Repeat the process daily

If you calculate RSI by hand, you can use a shortcut. Once you have 7 days' worth of data, replace steps 2 and 3 on all following days:

•  Multiply yesterday's average UP closing change by 6, add today's UP
closing change, if any, and divide the total by 7. That is your new
average UP closing change.

•  Multiply yesterday's average DOWN closing change by 6, add today's
DOWN close if any, and divide the total by 7. That is your new aver­
age DOWN closing change. Then proceed to step 4 (opposite page).

RSI fluctuates between 0 and 100. When RSI reaches a peak and turns down, it identifies a top. When RSI falls and then turns up, it identifies a bot­ tom. These turns come at different levels in different markets or even in the same market, during bull and bear periods.

Overbought and oversold levels vary from market to market and from year to year. There are no magical levels marking all tops and bottoms. Oversold and overbought signals are like hot and cold readings on a ther­ mometer. The same temperature has a different meaning in summer or in winter.

Horizontal reference lines must cut across the highest peaks and the low­ est valleys of RSI. They are often drawn at 30 and 70. Some traders use 40 and 80 levels in bull markets or 20 and 60 in bear markets. Use the 5 percent rule: Draw each line at a level beyond which RSI has spent less than 5 per­cent of its time in the past 4 to 6 months. Adjust reference lines once every three months.

Mass Psychology

Each price represents the consensus of value of all market participants at the moment of transaction. Closing price reflects the most important consensus of the day because the settlement of traders' accounts depends on it. When the market closes higher, bulls make money and bears lose. When the market closes lower, bears make money and bulls lose.

Most traders in all markets pay more attention to closing prices than to any other prices. In the futures markets, money is transferred from losers' to winners' accounts at the end of each trading day. RSI shows whether bulls or bears are stronger at closing time -the crucial money-counting time in the market.

Trading Rules

RSI gives three types of trading signals. They are, in order of importance, divergences, charting patterns, and the level of RSI.

Bullish and Bearish Divergences

Divergences between RSI and prices give the strongest buy and sell signals. They tend to occur at major tops and bottoms. They show when the trend is weak and ready to reverse (Figure 31-2).

1. Bullish divergences give buy signals. They occur when prices fall to a

new low but RSI makes a more shallow bottom than during its previ­ ous decline. Buy as soon as RSI turns up from its second bottom, and place a protective stop below the latest minor price low. Buy signals are especially strong if the first RSI bottom is below its lower refer­ ence line and the second bottom is above that line.

2. Bearish divergences give sell signals. They occur when prices rally to a new peak but RSI makes a lower top than during the previous rally. Sell short as soon as RSI turns down from its second top, and place a protective stop above the latest minor high. Sell signals are especially strong if the first RSI top is above its upper reference line and the sec­ond top is below it.

Charting Patterns

Classical charting methods work better with Relative Strength Index than with other indicators. Trendlines, support and resistance, and head-and- shoulders patterns work well with RSI. RSI often completes these patterns a few days in advance of prices, providing hints of likely trend changes. For example, RSI trendlines are usually broken one or two days before price trendlines.

•  When RSI breaks its downtrendline, place an order to buy above the
price trendline in order to catch an upside breakout.

•  When RSI breaks its uptrendline, place an order to sell short below the
price trendline to catch a downside breakout.

RSI Levels

When RSI rises above its upper reference line, it shows that bulls are strong but the market is overbought and entering its sell zone. When RSI declines below its lower reference line, it shows that bears are strong but the market is oversold and entering its buy zone.

It pays to buy using overbought signals of daily RSI only when the weekly trend is up. It pays to sell short using sell signals of daily RSI only when the weekly trend is down (see Section 43).

•  Buy when RSI declines below its lower reference line and then rallies
above it.

•  Sell short when RSI rises above its upper reference line and then
crosses below it.

More on RSI

Some traders try to find deeper meaning in RSI patterns. Some analysts have described formations called positive and negative reversals, which they said forecasted the extent of any price move using RSI patterns. So far, there have been no reports of conspicuous success using these patterns from any­ one but their promoters.