Relative Strength Index (RSI)
What is the RSI?
The Relative Strength Index (RSI), developed by J. Welles Wilder, is a momentum oscillator that measures the speed and change of price movements. The RSI oscillates between 0 and 100. Normally the RSI is considered overbought when it trades above 70 and oversold when it trades below 30. Signals can be generated by looking for divergences and failure swings. RSI can also be used to identify the general trend.
How does it work?
In an uptrend, the RSI tends to remain in the 40 to 90 range with the 40-50 zone acting as support. During a downtrend the RSI tends to stay between the 10 to 60 range with the 50-60 zone acting as resistance. These ranges will vary depending on the RSI settings and the strength of the security’s or market’s underlying trend.
How to calculate the RSI
RSI Step One = 100 – 100 / (1 + Average Gain / Average Loss)
The average gain or loss used in the calculation is the average percentage gain or loss during a look-back period. The formula uses a positive value for the average loss.
The standard is to use 14 periods to calculate the initial RSI value. For example, imagine the market closed higher seven out of the past 14 days with an average gain of 1%. The remaining seven days all closed lower with an average loss of −0.8%. The calculation for the first part of the RSI would look like the following expanded calculation:
55.55 = 100 – 100/(1 + (1% / 14) / (0.8% / 14) )
Divergence
If underlying prices make a new high or low that isn’t confirmed by the RSI, this divergence can signal a price reversal. If the RSI makes a lower high and then follows with a downside move below a previous low, a Top Swing Failure has occurred.
If the RSI makes a higher low and then follows with an upside move above a previous high, a Bottom Swing Failure has occurred.
Best Indicators to use with RSI
- The MACD can confirm that it is really time to buy or sell when RSI indicates a security is oversold or overbought.
- Moving average crossovers can also help RSI users to pinpoint the right time to make a trade.
- Long-term RSI uses RSI on a longer time scale, such as weeks or months, to identify a larger trend and ensure that short-term RSI trades are going in the right direction.
Limitations of the RSI
The RSI compares bullish and bearish price momentum and displays the results in an oscillator that can be placed beneath a price chart. Like most technical indicators, its signals are most reliable when they conform to the long-term trend.
Since the indicator displays momentum, it can stay overbought or oversold for a long time when an asset has significant momentum in either direction. Therefore, the RSI is most useful in an oscillating market where the asset price is alternating between bullish and bearish movements.
Useful tools that go with RSI
As the name implies, RSI is simply measuring relative strength of the underlying market. When using RSI to identify reversals it is important to incorporate other tools like candlestick analysis or trend line analysis. For example, if you find are reading a reversal candlestick near a trend line while RSI is diverging, then you have a trading signal being generated.
What markets can RSI be applied to?
Since RSI measures the relative strength of the underlying market, it is a technical tool that can be applied to nearly any market. However, it is commonly applied to the more liquid and larger markets like forex, stocks, and commodities.