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A type of technical trading system indicator called an oscillator, relative strength is used by equity market investors to determine the up-or-down momentum of a stock or index supply and demand. The usefulness/popularity of relative strength is based on the premise that it will peak or bottom in advance of the price of the stock or index doing so. The Relative Strength Index (RSI) measures the size, or magnitude, of a stock's recent gains against the magnitude of its recent losses. The resulting RSI values are scaled and plotted from 0 to 100, with 30 typically serving as the lower threshold indicating a stock is oversold and 70 the upper threshold indicating a stock is overbought. The concept of Relative strength and RSI were invented by Welles Wilder, who described them in New Concepts in Technical Trading Systems, which he self-published in 1978.
Relative strength is an exponential moving average of the "up" and "down" price moves based on the closing prices for each day in the RSI calculation period. The ratio of the exponential moving average of "up" days — i.e., the numerator — and "down" days — the denominator — in the period indicates the RSI. The RSI is set to 100 if there are zero "down" days in the period.
The volatility of RSI values increases with a shorter the time period used. A 7-day RSI, for instance, will be more volatile than a 21-day RSI. A stock's prices over the past 7 and 14 days are typical periods used to calculate RSI.
Convergence and divergence between a stock's RSI and its coincident price change are important when using RSI to determine whether to buy or sell a stock or index. Convergence is a situation in which a stock's price and its RSI move up in tandem. This is taken to be a bullish trading signal indicating that demand for the stock is growing; in other words, this suggests that that investors are accumulating the stock.
Divergence, on the other hand, is a situation wherein a rising or consistently high RSI coincides with a downward move in the stock's price. This is taken to be a bearish signal, indicating that prices are likely to move down. Typically taking place after a stock has run up in price, divergence as an indication of "distribution," i.e., that those who have held the stock on the way up are now booking profits and exiting by selling the stock on to new buyers.
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