The Relative Strength Index (RSI) is a technical indicator that can help traders to identify when an asset is oversold or overbought.
Once we are satisfied that the asset has moved too much in one direction or another, we can then position ourselves to benefit from a likely price reversion.
The RSI is a momentum oscillator, an indicator that works by gauging the degree to which an asset price has changed over a given time span, measuring the relative strength of days when the price moves up versus those days when the price moves down.
It therefore seeks to provide a relative judgement of the momentum behind a given asset’s recent price performance.
Conceived by J. Welles Wilder, a retired US technical analyst, the RSI indicator measures the speed and change of price movements, with a view to identifying overbought and oversold price levels. Wilder introduced the Relative Strength Index in his 1978 book New Concepts in Technical Trading Systems.
The RSI ranks as one of the most widely used technical trading tools in use today, alongside other indicators created by Wilder, such as the Average True Range, Average Directional Index and the Parabolic SAR.
The RSI oscillates between zero and 100, though 70 and 30 are traditionally viewed as the most critical numbers when it comes to this indicator.
An asset is thought of as overbought when the RSI is above 70. A popular strategy used by those who practise RSI trading is to wait until the RSI begins to fall below the 70 level before taking a short position in the hope of profiting from a retrace or trend reversal.
An RSI of 30 or below indicates that the asset could be oversold. At the lower end of the scale, a popular strategy used by those who practise RSI trading is to wait until the RSI begins to rise above the 30 level before taking a long position, in the hope of profiting from an upwards breakout or retrace to the upside.
Both these strategies are likely to be more successful when the RSI has been above or below the critical level for a reasonable length of time. In this way, a move across the critical RSI of 30 or 70 is likely to be all the more significant.
RSI stock formula
The formula for the RSI is:
100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change) ) ]
For the RSI, the usual time frame to compare up periods to down periods is a fortnight, so the average of upward price change and average of downward price change in the formula is typically that derived over 14 days.