Overbought, Oversold, Divergences in Relative Strength Index (RSI) indicators

Overbought, Oversold, Divergences in Relative Strength Index (RSI) indicators

💥 The Relative Strength Index (RSI) is an indicator developed by J. Welles Wilder, based on Momentum, but with improvements. With Momentum, two things usually happen:

1. If very unusual past data is used, it can cause a change in Momentum, even though there is very little movement in the current price.

2. There is a problem in finding the standard zone to capture the exact overbought/oversold zone. In Momentum, we only have a zero line, and we can only indicate a level of 1 or 100 (in the case of Rate of Change), but we can't determine how high the momentum must go up to be called overbought or how low it must go to be called oversold.

Hence, the RSI was invented to solve this problem. The calculation formula is as follows:


💥Provided that RS is the ratio between the 7-day exponential moving average of gains versus the 7-day exponential moving average of losses (regardless of the market), the number of days used. Like any other oscillator, with a small number of days, the RSI is very sensitive to changes, which is suitable for those who like to speculate on a day-to-day basis. Commonly seen values for the number of days used are 4, 9, and 14. In addition, the RSI is also a tool used to measure the strength of a stock price's fluctuation, whether it fluctuates in a way that is driven or has inertia. The RSI value is always between 0 and 100. If the RSI is high, it indicates that in the past several days, the price has moved higher than it has decreased. A low RSI value indicates that the price, in the past few days, on average, has decreased more than it has increased.

The rules that apply to the widely used RSI are as follows:

💥Overbought and Oversold levels are usually set at the RSI level of 70 or higher, indicating that the price has moved up excessively, and 30 or lower, indicating that the price has moved down excessively. Some traders wait for the RSI to cross the 30 line before buying, while others may use the moving average of the RSI as a signal and start trading when the line begins to point up in the oversold area (or pointing down in the overbought area in the case of selling). However, the past behavior of the RSI with its price during that period should also be taken into consideration as there are many instances where it may give erroneous results. Therefore, the mentioned rules should be considered together.

💥Price patterns may not be apparent in the price action but can manifest or be found first in the RSI, which can serve as an early warning signal. Resistance or support levels may also be more prominently seen on the RSI in price, which can act as support or resistance for the RSI. The RSI and price relationship can provide a useful signal for trading decisions.

RSI 02.png

💥Divergences occur when, for example, the price breaks through the previous peak, while the RSI fails to do so and remains in its original balance. This is an early warning that there is a chance that the price will decline in the future because the RSI is a measure of momentum. Even if the price continues to rise, the RSI may decline due to price inertia.

💥Divergence signals between the RSI and the price are often seen when the RSI fails or fails to swing. For example, while the RSI is in an upward direction and above the 70 line (overbought), but cannot create a new higher top and a new lower bottom. This is called a Top Failure Swing. Conversely, if the RSI is below the 30 line (oversold) in a downward direction but can create a new higher top and bottom, it is called a Bottom Failure Swing, which will be a reversal signal.

💥We can see that these important signs usually occur in the OB/OS bands. As mentioned above, the RSI performs best in this area. Another important characteristic of divergence in the OB/OS area is that the RSI fails to break the resistance from the tops or the OB/OS bands. If the old base is gone, it will warn of an upcoming reversal.

Attach files by dragging & dropping, , or pasting from the clipboard.