What is Relative Strength Index (RSI)?
Relative Strength Index (RSI) is a technical analysis indicator used to measure the magnitude and velocity of price movements in a financial instrument, such as a stock, currency pair, commodity, or index. It helps traders and analysts identify overbought or oversold conditions in the market. While the RSI can be a valuable tool for identifying potential trading opportunities, it is most effective when used in conjunction with other technical indicators and analysis methods.
Geeky Takeaways:
- Traders and analysts use the RSI in conjunction with other technical indicators and analysis techniques to make informed trading decisions.
- The divergence between the RSI and price movements can provide valuable signals for traders.
- The effectiveness of the RSI may vary depending on the timeframe used for calculation. Shorter RSI periods (e.g., 14 days) are more sensitive to price changes, while longer RSI periods may smooth out fluctuations.
An RSI reading above 70 is often interpreted as indicating that the asset is overbought, meaning the price may be due for a pullback or reversal. Conversely, an RSI reading below 30 suggests that the asset is oversold, potentially indicating a buying opportunity.
Table of Content
How Relative Strength Index Works?
1. Calculation of Average Gain and Average Loss: The RSI calculation begins by determining the average gain and average loss over the chosen time period.
2. Relative Strength: The relative strength (RS) is calculated by dividing the average gain by the average loss. This ratio indicates the magnitude of recent gains relative to losses. A higher RS suggests stronger upward momentum, while a lower RS suggests stronger downward momentum.
3. RSI Calculation: The RSI is then calculated using the formula,
This formula converts the RS into an oscillator that ranges between 0 and 100.
4. Interpretation of RSI Values: RSI values above 70 are generally considered overbought, suggesting that the asset may be due for a price correction or reversal. Conversely, RSI values below 30 are considered oversold, potentially indicating a buying opportunity. Traders often use these overbought and oversold levels as signals for potential trading opportunities.
5. Monitoring RSI Trends: Traders monitor the RSI trends over time to assess the strength and momentum of the underlying price movements. Rapid changes in RSI values can indicate shifts in momentum, while divergence between RSI and price movements can signal potential trend reversals.
Formula & Calculation of RSI
1. Determine the Time Period: RSI is calculated for a specific time periods, generally 14 days, but can be adjusted according to preferences.
2. Calculate Average Gain and Average Loss: For each day within the chosen time period,
- Calculate the price change (difference between today’s closing price and yesterday’s closing price).
- If the price change is positive (a gain), add it to the total gains for the period.
- If the price change is negative (a loss), add the absolute value of it to the total losses for the period.
- After calculating gains and losses for each day in the period, divide the total gains by the number of days to get the average gain, and divide the total losses by the number of days to get the average loss.
3. Calculate Relative Strength (RS): Divide the average gain by the average loss to get the Relative Strength (RS).
4. Calculate RSI: Calculate the Relative Strength Index (RSI) using the following formula,
5. Interpret RSI: The RSI value ranges between 0 and 100.
- A reading above 70 typically indicates that the asset is overbought.
- A reading below 30 typically indicates that the asset is oversold.
Why is RSI Important?
1. Momentum Assessment: The RSI is a momentum indicator that calculates the pace at which prices move as well as the degree of change of these movements. It delivers traders and investors with clarity about how the price moves, letting them know whether the trend is still stronger or not.
2. Overbought and Oversold Conditions: RSI helps sense market extremes and find areas where the prices are overstretched to one side or the other. Most readings over 70 characterize that an asset is overbought, which implies that its price will probably be due for a correction or reversal. Yet, if the reading of 30 and below indicates that the price is overly sold, then this suggests that the price may be undervalued and may be ready for a rebound.
3. Trend Confirmation: RSI supports the existing trend and sometimes also initiates a new trend with relevant signals. Thus, for instance, if an asset is in an uptrend and the RSI often is above 50, it implies that there exists a positive buying pressure, and in turn, the bullish tendency worsens. On the contrary, if RSI consistently stays beneath 50 rates while declining, it serves as a confirmation of selling pressure and further contributes to the trend of gaining value.
4. Potential Reversal Signals: Usually, RSI provides early indications that are accompanied by price reversals. Relationships between RSI and price action, as well as overbought and oversold readings, can hint the positive trend may get eroded and hence turn negative.
5. Risk Management: The RSI concept of trader management is in revealing prospects in the trade period when they can enter into or exit the trade. The trader can protect his capital by using “do not buy top” or “do not sell bottom” rules to prevent him from entering at poor prices which he might suffer some losses.
Benefits of RSI
1. Identifying Overbought and Oversold Conditions: Provides a tool for traders to see that the trend is deviating when an asset is overbought (RSI above 70) or oversold (RSI below 30).
2. Trend Confirmation: This applies the idea that the movement of RSI is more confirmation of trend strength where it is above 50 for an uptrend and below 50 for a downtrend and this aids traders in making informed decisions.
3. Generating Buy and Sell Signals: Gives the trading rules for successful trade decisions according to too-much-bought and too-much-sold market conditions.
4. Divergence Detection: Traders are given an alert when price movements start deviating from RSI movements which may indicate a change of trend.
5. Versatility and Adaptability: This can be utilized as a part of diverse financial toolkits and timeframes, customizing trading approaches and strategies for different traders.
Limitations of RSI
1. False Signals in Sideways Markets: RSI can generate false signals in sideways or non-trending markets, leading to premature trade entries or exits.
2. Whipsaw Effect: Rapid oscillations in RSI readings can result in frequent buy and sell signals, increasing the likelihood of whipsaw trades.
3. Lagging Indicator: RSI relies on past price data, making it a lagging indicator that may not provide timely signals during fast-moving market conditions.
4. Sensitivity to Timeframe: RSI effectiveness can vary depending on the chosen timeframe, requiring adjustment and optimization for different trading strategies.
5. Overreliance Risk: Traders may become overly reliant on RSI signals, ignoring other important factors such as market fundamentals or macroeconomic trends.
Relative Strength Index – FAQs
What is the Relative Strength Indicator (RSI) in trading?
The RSI is a relative strength oscillator that uses the speed (momentum) and degree (change) of price changes to generate its indicators. Its value varies between 0 and 100 and is employed to uncover overbought and oversold situations in the market.
Indicate the method that is used for the RSI calculation.
The RSI is determined through the mean of the average gain and the mean of the average loss over the period specified, which is usually 14 days. This formula means we have to divide the average gain by the average loss and then convert the answer into an oscillator ranging from 0 to 100.
Why is RSI important for traders?
RSI is one of the essential technical indicators to traders for not just identifying quick reversals but also for trend confirmation, signal generation, and risk management purposes.