Besides the DMI system, J. Welles Wilder is perhaps most widely known for the creation of his Relative Strength Index (RSI). This price-derived indicator is widely used to this day, not least because it is comparatively simple to generate, interpret and build into an automated trading system.

RSI looks at the relationship of rising closes to falling closes over a given, backward-looking time window to measure the rate at which price increases or decreases develop.

Typically 14 periods are used as a default setting but this can be flexed. The level of the RSI signals the strength of the trend and its slope indicates the rate of change in trend. When the RSI flags a momentum change from an extreme value it can foreshadow a similar move in asset prices.

Defined range

RSI moves within a range from zero to 100 so it becomes possible to set standard threshold values that signify extreme conditions and to make comparisons between the readings for different stocks or markets.

When it comes to the RSI indicator, these threshold values are most often set at 70 and 30 though some traders prefer to use 80 and 20, particularly if a stock’s price action is volatile.

Moves above the upper extreme level signal the market may be overbought and falls below the lower limit suggest a security is oversold.

Note that when a price trend is particularly strong, an overbought or oversold signal may simply result in a consolidation rather than a reversal. Under such circumstances it may be best to tighten stop losses and protect unbanked profits rather than to reverse the trade.

During an uptrend the indicator will tend to trade between 40 and 80 while in a downtrend it will oscillate between 20 and 60 although from time to time the RSI can depart from the corresponding price trend, as happens with all indicators.

Sometime the measure will fail to follow suit even as prices make successively higher short-term peaks. This is known as bearish divergence and is considered to be a warning that a price correction is likely.

The reverse can occur when successive price lows are not replicated in the RSI and so bullish divergence occurs, potentially heralding the end of a downtrend. Research suggests these divergences result in relatively short-term corrections rather than major changes of direction.

Subsequent thinking has introduced the idea of positive and negative reversals in the RSI. The former occurs when a new lows in the RSI are not mirrored in successively lower dips in price. This formation seems to foreshadow a fresh rise in the price. If higher highs are seen in the RSI but the corresponding peaks in price fail to follow this signals a negative reversal and the risk of a decline in market prices.

In the early part of 2012 BP (BP.) showed bearish divergence (BR) alongside a share price peak close to 500p. The shares dropped and in late April a negative reversal (NR) signalled further weakness. Bullish divergence (BL) appeared in May and BP rallied from 400p to 450p by August.

120913 BP

The FTSE 250's chart shows when it was oversold (blue vertical lines) and overbought (red vertical lines) and the moves that followed. Between ‘A’ and ‘B’ and ‘C’ and ‘D’ the rising trend was strong and the RSI stayed above the 50% level.

120913 250

Issue Date: 23 Dec 2013