The Relative Strength Index ("RSI") is a popular oscillator. It was first introduced by Welles Wilder in an article in Commodities (now known as Futures) Magazine in June, 1978. Step-by-step instructions on calculating and interpreting the RSI are also provided in Mr. Wilder's book, New Concepts in Technical Trading Systems.
The name "Relative Strength Index" is slightly misleading as the RSI does not compare the relative strength of two securities, but rather the internal strength of a single security. A more appropriate name might be "Internal Strength Index." Relative strength charts that compare two market indices, which are often referred to as Comparative Relative Strength.
When Wilder introduced the RSI, he recommended using a 14-day RSI. Since then, the 9-day and 25-day RSIs have also gained popularity. Because you can vary the number of time periods in the RSI calculation, I suggest that you experiment to find the period that works best for you. (The fewer days used to calculate the RSI, the more volatile the indicator.)
The RSI is a price-following oscillator that ranges between 0 and 100. A popular method of analyzing the RSI is to look for a divergence in which the security is making a new high, but the RSI is failing to surpass its previous high. This divergence is an indication of an impending reversal. When the RSI then turns down and falls below its most recent trough, it is said to have completed a "failure swing." The failure swing is considered a confirmation of the impending reversal.
In Mr. Wilder's book, he discusses five uses of the RSI in analyzing commodity charts. These methods can be applied to other security types as well.
Tops and Bottoms.The RSI usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart.
Chart Formations.The RSI often forms chart patterns such as head and shoulders (page 215) or triangles (page 216) that may or may not be visible on the price chart.
Failure Swings(also known as support or resistance penetrations or breakouts). This is where the RSI surpasses a previous high (peak) or falls below a recent low (trough).
Support and Resistance.The RSI shows, sometimes more clearly than price themselves, levels of support and resistance.
Divergences.As discussed above, divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the RSI. Prices usually correct and move in the direction of the RSI.
For additional information on the RSI, refer to Mr. Wilder's book.
The following chart shows PepsiCo and its 14-day RSI.
The RSI is a fairly simple formula, but is difficult to explain without pages of examples. Refer to Wilder's book for additional calculation information. The basic formula is: