Relative Strength Index (RSI)

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What is the Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a technical analysis tool that serves as a momentum oscillator, measuring the speed and change of price movements of securities.

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The RSI provides values that range from 0 to 100, which are used to identify the general trend, overbought conditions, or oversold conditions and divergence in the market. It was devised by Welles Wilder Jr, a technical analyst who also developed the Average True Range (ATR).

When applied to a price chart, the indicator looks like this:

RSI Example

No technical indicator offers a ‘silver bullet’ to win every trade, but it can clearly be seen at first glance that the turning points in the RSI generally correspond to the major turning points in the price.

Techopedia Explains the RSI Meaning

Techopedia Explains the RSI Meaning

What if there was a way to glimpse into the market’s future movements? The Relative Strength Index (RSI) offers just that – an ‘inside’ look at the momentum that drives market trends.

The Relative Strength Index (RSI) is a momentum oscillator plotted on a scale from 0 to 100, designed to indicate the momentum’s intensity within the market. This scale allows for a quick visual assessment of a security’s momentum, making the RSI a valuable component of technical analysis.

The RSI aims to smooth out short-term price volatility to reveal longer-term trends and reversal opportunities, utilizing a moving average of price changes.

How the Relative Strength Index Works

This indicator is designed to display information about the current and historical strength or weakness of a market, based on the closing prices of a recent trading period.

This is easiest to visualize on the candlesticks when there is a big change in the closing price.

How the Relative Strength Index Works
Source: TradingView

In other words, a high closing price often indicates strong market sentiment and buying pressure, implying an upward trend and likely more strength. Conversely, a low closing price suggests weak market sentiment and selling pressure indicating a downward trend and maybe more weakness. Closing prices are indicative of the final consensus on value in the market at that point in time.

Relative Strength is all about comparing upward movements of prices with downward movements over a set period of time. RSI uses these relative moves to create a number that traders and investors use to get a feel for where momentum may be heading.

RSI Formula

The RSI calculation involves a two-step process aimed at comparing the average gains against the average losses over a specified period, typically 14 days for many traders.

The formula is as follows: RSI = 100 – (100 / 1 + RS)

Where:

RS (Relative Strength) is the ratio of the average gain of the up periods to the average loss of the down periods over the specified period.

The calculation of RS is broken down into two main components:

  1. Average Gain: The sum of all gains divided by the period length.
  2. Average Loss: The sum of all losses (expressed as positive values) divided by the period length.

Each new RSI value is based on the previous period’s averages, updated with the current period’s gain or loss. This method ensures that the RSI reflects the most recent changes in market conditions, making it a dynamic and responsive indicator.

RSI Calculation Example

Let’s consider a simplified scenario for Relative Strength Index calculation with Nvidia (NVDA) stock over a 14-day period. The main unknown that needs calculating to arrive at the RSI is the RS, which is the ratio of the average gain to the average loss.

Let’s assume NVDA stock experienced an average gain of $1 on its up days and an average loss of $0.50 on its down days over the 14-day period.

The RS would be calculated as follows:

Average Gain: $1

Average Loss: $0.50

RS: $1 / $0.50 = 2

Plugging the RS into the RSI formula gives us:

RSI = 100 − (100 / 1+2) = 66.67​

A Relative Strength Index indicator value of 66.67 suggests that the stock has been experiencing strong upward momentum, while not quite being above the overbought threshold of 70 (more on this shortly).

Overbought and Oversold RSI Levels

The scale runs from 0 to 100, with specific thresholds set to identify overbought and oversold conditions. These thresholds are not absolute indicators of a market reversal but suggest that a security is under significant buying or selling pressure, respectively.

Overbought Conditions (RSI > 70)

When the RSI exceeds 70, it may indicate that a security has been bought more aggressively than usual, pushing its price potentially higher than its intrinsic value. This condition is often seen as a signal that the price could correct downwards in the near future, as the buying momentum may not be sustainable.

Overbought vs. Oversold RSI

Overbought vs. Oversold RSI
Source: Fidelity

Oversold Conditions (RSI < 30)

Conversely, an RSI below 30 suggests that a security has been sold more aggressively, possibly driving its price lower than its true worth. This scenario can signal that a price increase might be on the horizon, as the selling pressure begins to wane, and buyers may consider the security undervalued.

How to Trade Overbought and Oversold RSI

In practice, traders and investors watch for the RSI to cross these threshold levels as part of their market analysis strategy.

If a stock’s RSI moves from above 70 to below it, this might be interpreted as a sell signal. Similarly, an RSI moving from below 30 to above it could be seen as a buy signal.

Condition RSI Movement Interpreted Signal Market Condition Consideration
Overbought Above 70 to Below Potential Sell Signal Caution during a strong uptrend, as securities may remain overbought.
Oversold Below 30 to Above Potential Buy Signal Caution during a strong downtrend, as securities may remain oversold.

Additionally, it is worth bearing in mind that in trending markets, securities can remain oversold or overbought for quite some time. Consequently, while the Relative Strength Index indicator is an important tool for determining potential points of entry/exit; reliance only on such indicators without respect for broader market context can lead to premature decisions.

The RSI and Price Divergence

This occurs when there is a divergence between the direction of the RSI trend and that of price, suggesting a loss in momentum that might herald a change in direction.

The importance of divergence lies in its ability to signal an early reversal point for possible trends as it identifies disparities between price ‘movement’ versus its ‘magnitude’ (i.e., momentum).

What is Divergence? A divergence between price and momentum is a possible sign that the current trend may not be as strong as the price action suggests.

Bullish and Bearish Divergence

Bullish Divergence: The price records a lower low, but the RSI forms a higher low. This indicates that despite the decline in price, the downward momentum is weakening, which could lead to a bullish reversal (an increase in price).

Bullish and Bearish Divergence
Source: Stockchart

Bearish Divergence: Conversely, when the price achieves a higher high but the RSI charts a lower high, it points to a bearish reversal. This scenario suggests that even though the price is climbing, the upward momentum is losing strength, and a price drop may be forthcoming.

Application of RSI Divergence in Trading

Traders often use divergence as a signal to prepare for a potential entry or exit point, depending on their market position and strategy.

Bullish DivergenceBearish Divergence

Purpose

Anticipate a price increase after a period of falling prices.

Action

Potential Buy or Cover Short

Consideration

Caution in strong uptrend

Purpose

Anticipate a price decline after a period of rising prices.

Action

Potential Sell or Enter Short

Consideration

Caution in strong downtrend

Limitations of RSI and Price Divergence

While divergence can be a powerful indicator, it has its limitations. The primary challenge is timing, as divergences can occur well before the actual trend reversal happens, leading to premature trading decisions. Additionally, in strongly trending markets, divergences may frequently appear without a corresponding significant trend reversal, potentially leading to false signals.

The Role of RSI in Investment Decisions

Its application varies, catering to different investment styles and risk tolerances. The RSI’s flexibility allows it to support aggressive growth strategies or more conservative approaches focusing on risk management. It’s essential, however, to complement RSI analysis with other indicators and market analysis for a well-rounded strategy.

The RSI and Index Funds

The Relative Strength Index (RSI) is a practical tool for investors in index funds, particularly Exchange-Traded Funds (ETFs), due to their characteristics like high liquidity and real-time pricing. These features make the RSI especially relevant for gauging market sentiment and timing trades effectively.

Index funds, especially ETFs, mirror the performance of indices and offer the advantage of trading like stocks. This liquidity and the ability to trade throughout the trading day enable investors to respond swiftly to RSI signals. Mutual funds do not lend themselves so well to technical analysis because they are priced once per day, hindering real-time trading decisions based on intraday market movements or other critical indicators like the RSI.

Pros and Cons of RSI

Benefits

  • Identifies overbought/oversold conditions
  • Aids in predicting price movements
  • Offers user-friendly functionality
  • Provides timely signals for informed decisions
  • Potentially enhances profitability

Limitations

  • Produces false signals in volatile markets
  • Tends to stay overbought/oversold during strong trends
  • Exhibits reduced effectiveness as a standalone tool
  • Requires complementing with other analysis tools

The Bottom Line

The Relative Strength Index (RSI) is a momentum oscillator that helps identify overbought or oversold conditions, signaling potential market reversals. Its application spans individual securities to index funds, offering insights into market sentiment.

While beneficial for timing trades, the RSI’s effectiveness is enhanced when used alongside other analytical tools.

FAQs

What is the relative strength index in simple terms?

What is a good RSI score?

What does the Relative Strength Index tell you?

What does an RSI of 70 mean?

References

  1. Deltasociety (Deltasociety)
  2. NVIDIA Corp (Google)
  3. Relative Strength Index (RSI) (Fidelity)
  4. Relative Strength Index (RSI) (School.stockcharts)
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Jasper Lawler
Financial expert
Jasper Lawler
Financial expert

Jasper cut his teeth on Wall Street as a stockbroker and honed his analytical skills with the City of London's top trading firms. Today, he applies his financial expertise to content creation as the founder of Trading Writers, a niche content marketing agency for the finance sector. Jasper's articles can be found on Techopedia, Seeking Alpha, UK Investor Magazine, Trade2win, Investing.com, FXStreet, Trading212.com, FlowBank.com, and Capital.com. His analysis has been quoted in prestigious publications such as the Financial Times, Bloomberg, Reuters, AFP, and City AM. Jasper's transition from stockbroker to content creator highlights his deep understanding of the financial markets…