What it is:
The RSI indicator mirrors and anticipates price patterns in the underlying stock or index chart. The indicator's designer, Welles Wilder, intended for the RSI Indicator to help traders chart formations not obvious on a bar chart. The RSI sometimes gives a signal several periods in advance of the price chart, providing valuable lead time to a trader.
How it works (Example):
RSI is calculated by taking an average of up and down closes for the past "n" periods, often 14 days. This calculation is then plotted on a panel above or below the price chart. Since RSI is plotted as a point, it creates a line chart instead of a candle or bar chart. These line graphs dictate the kind of patterns RSI forms. Some of the most commonly formed patterns are head and shoulders tops and bottoms, as well as triangles of all varieties. Occasionally, rectangles and other patterns like double or triple tops and wedges can relative strength lineur.
These formations can be created over a very short period of time -- such as four or five days -- in which case a Minor top in the stock is likely. Sometimes, the RSI formation can take shape over several weeks or months. These are far more significant patterns and can signal important Intermediate reversals on the price chart. Often, they will warn of and correlate with an Intermediate trendline break on the price chart.
RSI is calculated so that support and resistance levels in the indicator have technical significance. Trendlines can also be drawn on the RSI line. The combination of support and resistance with a trendline means that RSI frequently forms various price patterns. These can take the shape of symmetrical, ascending and descending triangles. Occasionally, rectangles also emerge on the RSI chart. Less frequently, RSI will form head and shoulder formations, pennants and wedges. Again, these formations typically can be spotted more clearly on the RSI chart than the price chart and often precede the action in the price chart by several periods.
On the historical chart of the Nasdaq Composite below, note that a descending triangle formation has formed. Note the bearish momentum divergence in RSI, as the Composite made a higher peak in price, but a lower peak on RSI in April. At the end of the charted period, RSI is in danger of breaking below support formed in mid April. In that event, the likelihood of a sharp break below Nasdaq support at 2300 would increase dramatically.
Why it Matters:
RSI price patterns, when combined with the tools of divergence and failure swings, can give powerful warnings of future movement on the price chart -- up to a day or two in advance. Therefore, swing traders should make a habit of carefully monitoring the message of the RSI line in order to clarify and forecast changes in the price chart.