Relative Strength Index (RSI)
The relative strength index (RSI) was created by J. Welles Wilder Jr. in the late 1970s. It is a momentum oscillator which measures the rate of the rise or fall of the stock. The RSI values move between 0-100. Just as the name suggests, the indicator finds how strong or weak the stock or crypto is relative to the specified point.
The RSI is plotted by using the gains and losses as a ratio. The Signal line is drawn as a reference or yardstick to measure where the RSI is with reference to the prevailing market conditions. Usually, the timeframe used for RSI is 14 days. However, the time could be adjusted as per the user’s discretion.
The Signal line is plotted by using the average price of the security. Whenever the RSI is above the Signal, the security is referred to be bullish and when the RSI drops below the Signal, the security is bearish.
Moreover, the RSI has two extreme regions, the overbought and oversold regions. When the RSI value goes above the 70 mark, the stock or crypto is assumed to be overbought. In other words, it means that the security is bought more than it is sold in the market. Oversold is when the RSI value reaches below the 30 level. The security is being sold more than it is being bought is what oversold means.
Whenever either of the above happens the supply-demand equilibrium is dismantled. When security is overbought or many are buying it, there will be a shortage in supply and the demand will rise. This rise in demand will intuitively shoot the price up. And the opposite happens when it is oversold.
When a security is either oversold or overbought, it is expected that the market would correct the prices and the RSI would move in the opposite direction. However, the above-stated thesis is not a necessity although it happens most of the time. There is also the tendency for the security to remain in these extreme regions for a long period of time.
Meanwhile, when the RSI has a value greater than 30 but less than 70 (30<RSI<70) then, it is neutral as shown in the chart above.
Usually, the RSI moves in the direction the security moves. For instance, if the security makes a higher low, the RSI also should make a higher low. However, when there is a divergence, the RSI and the security move in opposite directions.
The above chart demonstrates one such instance. The RSI made lower lows when the security made higher lows, hence, this is a bearish divergence. This shows that the uptrend of the security would come to an end shortly. When the RSI moves higher lows while the security makes lower lows, then, it is a bullish divergence.