What is the RSI?
The Relative Strength Index (RSI) is a momentum price-following oscillator that measures the speed and change of price movements over a given time period. This oscillator is designed to help traders identify whether an asset is oversold or overbought.
The indicator can be used when looking at several different types of time frames, such as minutes, hours and days. The RSI can also be calculated over different time periods: 9-unit, 14-unit and 25-unit periods are the most commonly used. It’s worth noting that the smaller the time period used for calculation, the more volatile the RSI will be.
Shorter or longer time frames are used for alternately shorter or longer outlooks. The RSI is a leading indicator, designed to get you into a profitable trade earlier than lagging indicators. However, they are less reliable and can often produce false signals.
What is a momentum indicator?
A momentum indicator are those categorised by the fact that they measure the speed, or velocity, of market price movements. They are in essence a way of realising a shorter-term trend in a security’s price movement and provide an indication of the sustainability of shorter-term movements by producing overbought and oversold signals.
How to trade using the RSI
The RSI indicator oscillates between 0 and 100, with 70 and 30 traditionally viewed as the bands that indicate whether an asset is overbought or oversold. An asset is considered overbought when RSI is above 70, which is a sign of a possible trend reversal. Traders can use this oscillator and wait until the RSI falls below the 70 level to take a possible short position.
On the other hand, when the RSI is 30 or below, the indicator suggests that an asset is oversold. The idea is to take a long position when the RSI rises above 30, in the hope that the market is appreciating.
Alternatively, more extreme high and low levels can be used as the bands for the RSI. The indicator will less commonly reach these levels, but they do indicate stronger momentum (e.g. bands at 90 and 10, or 80 and 20).
You can use the RSI 50 level, the centerline, to confirm that a price trend is occuring. A downward trend is confirmed when the RSI crosses from above 50 to below 50. Similarly, an upward trend is confirmed when the RSI crosses above 50.
Another use of the RSI indicator is to look for divergence between the RSI and asset price. When the price hits a new high, and the RSI does not, this is bearish divergence in an uptrend.
When the price hits a new low, and the RSI does not, this is bullish divergence in a downtrend. When divergence occurs, there is often a higher probability of price retracement; a temporary reversal in the direction of a stock's price that goes against the prevailing trend. This can present short-term sell and buy signals.
Who invented the RSI?
The Relative Strength Index was formulated by mechanical engineer turned trader and technical analyst, J. Welles Wilder Jr. First, which he presented in his book ‘New Concepts in Technical Trading Systems’.
At this time, Wilder was trading stocks and commodities and was met with a problem. Namely, that even if the price trend with strong and rising, he didn’t immediately know whether the price was too expensive to open a long position. The inverse also holds. This is what Wilder had in mind when he conceived the RSI.
Today, the RSI has become one of the most popular oscillator indicators and is commonly used by many traders, with varying RSI trading strategies.
RSI Formula: How is the RSI calculated?
The RSI is calculated by normalising the relative strength factor (RS). Relative strength is measured by average gain divided by average loss. The average gain is the sum of the upward price changes over last X time periods – typically 14 as recommended by the indicators developer – divided by the number of periods to attain the average.
The average loss is the sum of downward price changes over the same amount of periods, divided by that same number of periods. The relative strength factor (average gain divided by average loss) is then converted to a relative strength index between 0 and 100, to produce the RSI = 100 - 100 / (1 + RS) - this is the RSI calculation.
RSI vs stochastic oscillator: what’s the difference, and can you trade with the RSI and stochastic oscillators?
The RSI and stochastic oscillators are both momentum indicators within technical analysis. Indeed, they are two of the most popular oscillators in this field. They are similar in their use, but their mathematical foundations are different. The RSI is looking at the average gains against the average loss over a set number of periods. But the stochastic oscillator considers the closing price relative to the highest high and lowest low within a given timeframe.
Some traders, in order to provide a stronger trading signal, combine the RSI and stochastic oscillators. Although the two indicators signal at different levels, it is the combination of the two signals that confirm a stronger signal to the trader. It should be noted that due to the similarity of these indicators. Combining them does not necessarily provide a stronger trading signal.