The Relative Strength Index (RSI) is a widely-used momentum indicator in technical analysis. It measures the speed and change of price movements, helping investors and traders assess whether a stock or other asset is overbought or oversold.
Formula and Calculation
The RSI is calculated using the following formula:
Where:
- \(RS\) (Relative Strength) = \(\frac{\text{Average Gain}}{\text{Average Loss}}\)
The typical look-back period for RSI is 14 days, although this can be adjusted to suit different trading strategies.
Example Calculation
Assume the following price changes over a 14-day period:
- Gains: $8, $6, $7, $5, $10, $3, $6, $8
- Losses: $4, $3, $2, $4, $5, $6
The average gain = \(\frac{8+6+7+5+10+3+6+8}{14}\)
The average loss = \(\frac{4+3+2+4+5+6}{14}\)
Relative Strength (RS) = \(\frac{\text{Average Gain}}{\text{Average Loss}}\)
Substitute RS into the RSI formula to get the RSI value.
Interpretation of RSI Values
- RSI values range from 0 to 100.
- An RSI above 70 often indicates that an asset is overbought.
- An RSI below 30 often indicates that an asset is oversold.
Historical Context
The RSI was developed by J. Welles Wilder Jr. and introduced in his 1978 book, “New Concepts in Technical Trading Systems.” Since then, it has become one of the most popular tools in technical analysis.
Application in Trading
Overbought and Oversold Conditions
Traders use RSI to identify potentially profitable points:
- Overbought: When RSI is above 70, it may signal that the asset is overpriced and could undergo a downward correction.
- Oversold: When RSI is below 30, it may signal that the asset is underpriced and could experience a price increase.
Divergences
- Bullish Divergence: Occurs when price hits a new low, but RSI forms a higher low.
- Bearish Divergence: Occurs when price hits a new high, but RSI forms a lower high.
Related Terms
- Stochastic Oscillator: Another technical indicator for comparing the closing price of a security.
- MACD (Moving Average Convergence Divergence): Used to identify changes in the strength, direction, momentum, and duration of a trend.
- Bollinger Bands: A method for pricing volatility.
FAQs
Can RSI be used in all types of markets?
What are the limitations of RSI?
How can I change the standard 14-day period?
References
- Wilder, J. Welles Jr. “New Concepts in Technical Trading Systems.” 1978.
- “Technical Analysis of the Financial Markets” by John J. Murphy.
- Investopedia: Relative Strength Index
Summary
The Relative Strength Index (RSI) is a powerful momentum indicator that helps traders evaluate market conditions and make informed trading decisions. By measuring price changes, RSI identifies overbought and oversold conditions, offering potential buy or sell signals. Though it has limitations, when used in conjunction with other indicators, RSI is an invaluable tool in technical analysis.
