James HesterThe 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.
Momentum oscillator
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.
J. Welles WilderConceived 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.
Critical numbers
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 chart. Source: StockCharts.comRSI 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.
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In practice, you should never need to use the formula to calculate the RSI yourself as it is widely available as part of the software toolkit provided by trading platforms.
Using RSI
Along with applying the standard rule to identify overbought or overvalued conditions when the RSI is above 70, or oversold/undervalued situations when the RSI is below 30, the RSI chart can also be used to reveal standard technical charting patterns and signals.
For instance, the RSI chart can be used to identify levels of price support and resistance in the same way as a standard candlestick price chart. Just like a standard chart, the RSI can identify common chart patterns such as double tops and bottoms.
As an example, suppose the RSI chart prints a double top at 80 over a given time frame, indicating a key level of resistance. The context for this could be that the asset has been in an uptrend but is about to experience a trend reversal.
As in the case of a double top on a standard candlestick chart, we may choose to take a short position on the asset as the price falls back, on this occasion implementing a short position when the RSI moves below the critical value of 70.
In this way, the RSI can help confirm the validity of the technical signals we are receiving from standard charting patterns. A double top or bottom on a candlestick price chart may well be replicated on an RSI chart if the pattern is a valid signal.
RSI tips
While a move in the RSI through 70 may point to an ideal point to sell or go short on the asset, as ever with technical indicators it’s important to look at the evidence provided by alternative technical signals, as well as any other relevant fundamental information.
Short-term volatility has scope to create false sell or buy signals from the RSI when very significant, sharp price movements occur. For this reason, some investors also prefer to use a higher or lower RSI threshold to define when an asset is overbought or oversold.
Therefore, rather than 70, some traders may classify an asset as overbought only when the RSI is at 75 or 80. At the lower end, some may choose to deem assets as having been in an oversold condition when the RSI is at 25 or 20.
RSI chart for McDonald's. Source: StockCharts.comPowerful indicator
The RSI can be a powerful technical indicator, helping us to identify opportunities to go long or short in assets. As with other technical indicators, it’s important not to use the RSI in isolation.
Along with fundamental information such as news flow, RSI signals can be used in combination with a variety of other technical indicators to help us make better trading decisions.
As when trading with other technical indicators, it’s advisable to use a stop loss when trading with the RSI.
