RSI in Stock Trading

Indicators

• RSI (Relative Strength Index) created by Welles Wilder (1978) is a momentum oscillator
• RSI aims to identify market situations where the stock is either too expensive or too cheap
• The default parameter for RSI is 14, but other parameters (e.g., 9 and 25) can be used

RSI Calculation

• RS is calculated as the average of raw close-up prices divided by the average of raw close-down prices.
• Then, RSI is calculated using the formula: RSI = 100 - (100 / (1 + RS))

RSI Calculation Example (14-period)

• Record closing prices for 14 periods
• Calculate the number of times the closing price was higher than the previous one (H)
• Calculate the number of times the closing price was lower than the previous one (L)
• Calculate RS = H/L
• Utilize the formula RSI = 100 - (100 / (1 + RS)) to calculate RSI

RSI Usage

• Oscillator operating around the neutral line (50).
• Important levels: 30 and 70 (or 20 and 80).
• Values above 70 indicate overbought conditions.
• Values below 30 indicate oversold conditions.
• Entry signals:
  • Cross above 70 with downward movement suggests a sell entry.
  • Cross below 30 with upward movement suggests a buy entry.
• Neutral line: 50

RSI Application (Example with IBM)

• RSI graph is overlaid on a stock chart.
• RSI value may be useful in determining when the overbought or oversold conditions are present
• The overbought and oversold zones are usually indicated in charts above 70 or below 30

RSI Combinations with Other Indicators

• RSI is not optimal for strong trend markets.
• Avoid combining RSI with other indicators like Stochastic, or Williams %R, because they often lead to duplicate or contradictory signals.
• Wilder recommends employing trend indicators (like ADX) to filter spurious signals.

RSI Failure Signals

• Failure swings (tops and bottoms) occur when the price fails to reach a previous extreme.
• Top failures occur when the price doesn't exceed a previous high while RSI may still signal a potential selling opportunity.
• Bottom failures occur when the price does not exceed a past low.

Divergence in RSI

• RSI divergence occurs when a security's price makes a new high or low, but its RSI does not.
• When price and RSI make opposing movements, this is called divergence.
• Bearish divergence: Occurs when price makes a new high, but RSI fails to do so (suggesting a potential sell).
• Bullish divergence: Occurs when price makes a new low, but RSI fails to do so (suggesting a potential buy).

A/D (Accumulation/Distribution) Line

• Developed by Marco Chaikin
• Aims to determine whether buyers or sellers are controlling the market.
• 'Accumulate': Market controlled by buyers
• 'Distribute': Market controlled by sellers.

A/D Calculation

• CLV: Calculates the relative closing price's position. The formula is: CLV = [(Close - Low) - (High - Close)] / (High - Low)
• A/D = CLV * Volume

A/D Usage

• Look for positive/negative divergence.
• Upward price with downward A/D: Traders may be finishing accumulation.
• Downward price with upward A/D: Traders may be finishing distribution
• A/D alone is not for entering positions. It's a supplementary indicator.