What Is The Relative Strength Index (RSI)?
The relative strength index (RSI) is a mathematically derived indicator used in the technical analysis of financial instruments. Classified as an oscillator, RSI attempts to quantify pricing momentum through the examination of a given security's realised gains and losses.
Traders and investors use the RSI calculation to determine whether or not a security can be considered overbought or oversold. Upon this designation being made, bullish or bearish trading signals may be applied to price movements.
How To Calculate RSI
To fully answer the question of "what is the RSI," one must first understand how it is derived. In order to calculate the RSI for a specific security, the following formula is used:
- RSI = 100 - [100/(1+RS)]
- Relative Strength (RS): This is the key component in the calculation. RS for the defined period = Average Gain / Average Loss.
- Average gain: Gain is defined as being a positive rate of change in the periodic closing price of a security. For instance, if security ABC has a closing value of US$100 for period one, and US$105 for period two, then ABC has realised a gain of US$5. As the period changes in length, the average gain becomes a total of the observed positive gains for the period divided by the period itself: Total Gain / Period.
- Average loss: In contrast to gain, a loss occurs when the difference between the periodic closing prices of a security is negative. If security ABC closes at US$100 for period one, and US$95 for period two, then there is a realised loss of US$5. In order to calculate the average negative change of price movements, the total amount observed during losses for the period is divided by the period itself: Total Loss / Period.
- Period: The default period used for the RSI calculation is 14. It is important to remember the period can be adjusted to account for varying market conditions. Differing products, timeframes or overall market state can greatly influence the inherent volatility facing an actively traded financial instrument. Depending upon the situation, the period used for the RSI calculation may need to be adjusted to more accurately reflect current trading conditions.
RSI is a normalised technical indicator. Indicators that are normalised have pre-defined upper and lower values, or exist on a scale. In the case of RSI, the scale ranges from a low value of zero to a high value of 100. Using this scale, traders can determine whether or not a security is currently being overbought or oversold. This is contrary to the popular MACD indicator, where exponential moving average (EMA) values are used to quantify market state.
Generally, an RSI value of 30 or less is a signal that a security is undervalued, and may be poised for a rally in price. RSI calculations of 70 or greater are viewed as a sign that a security is becoming overvalued and a subsequent drop in price may be forthcoming. In either case, one may use the RSI indicator in reversal strategies or to predict a forthcoming downtrend or uptrend.
What Is RSI Trading?
In 1978, technical analyst and trader J. Welles Wilder Jr. first introduced the concept of RSI in his book "New Concepts In Technical Trading Systems." Since then, RSI has been applied to a wide variety of financial instruments including those actively traded on the futures, equities and forex markets. In addition, RSI has been adapted to trading practices encompassing many different time frames, ranging from short-term intraday trading to long-term investing.
Among traders and investors, RSI remains one of the most popular technical indicators in use today. Typically, it's used in concert with trend lines, assorted momentum oscillators, predetermined support and resistance levels or chart patterns in order to place the price action of a security into context. Accordingly, RSI is often a contributor in the identification of indicator confirmation, divergence, or crossovers. However, like all other technical indicators and tools, RSI does face a few challenges.
In technical analysis, confirmation is the process of using one indicator to reinforce the validity of another. Due to its user-friendly 0-100 scale, many traders view the RSI as a valuable confirmation device.
For example, assume that one is trading the EUR/USD using Fibonacci retracements to enter strong trends. In the case of a EUR/USD bullish trend, the Fibonacci retracements are placed on the price chart using a defined swing high and swing low as anchor points. Accordingly, the trader is looking to buy a EUR/USD pullback in price from a periodic high.
If price hits a viable pullback level, such as 38.2% or 62.8%, a buy is suggested. At this point, an oversold RSI reading of 30 or below may be used to confirm the validity of the buy signal.
Crossovers, Bullish and Bearish Divergence
Bullish divergence and bearish divergence are highly scrutinised RSI phenomena. Below is a brief primer on each:
- Bullish Divergence: Bullish divergence develops when an oversold reading (0-30) is followed by a higher low in the RSI that corresponds with a lower low in price. This is interpreted as a bullish signal that anticipates a periodic new high in price.
- Bearish Divergence: Bearish divergence develops when an overbought reading (70-100) is followed by an RSI lower high and a corresponding higher high in price. Cases of bearish divergence are viewed as sell signals.
Divergence is only one way in which RSI is used in trading strategies. Other popular ways are known as crossovers. RSI crosses occur when the RSI "crosses over" the 30 or 70 default levels. If the RSI crosses above 70, one may be inclined to sell a security; if it crosses below 30, a buy may be in order. In this way, RSI can be traded as a standalone indicator without confirmation or divergence.
Like all indicators, the RSI does have a set of unique drawbacks. No indicator, tool, strategy or system is 100% accurate. Accordingly, the application of proper risk management parameters is recommended when trading the RSI.
False Indications Of Market Reversal
The first major drawback is that trending markets can provide RSI calculations that remain in overbought and oversold areas for long periods of time. This is problematic in that false indications of market reversal are created, prompting traders to adopt a contrarian position within the trending market. Unfortunately, these "false signals" can be costly and produce significant capital loss in strong trends.
When used on a short-term intraday basis, a momentary spike in pricing volatility can skew the RSI calculation itself, and produce an inaccurate value. As a result, a security can appear to be overbought or oversold when it is not.
In flat or rotational markets, RSI values may remain between overbought and oversold levels for extended periods of time. While the RSI doesn't produce an abundance of false signals in flat markets, it also offers the trader little guidance in such situations. The result can be long periods of inactivity or the execution of ill-advised trades.
Modern charting software applications typically include RSI within the trading platform itself and afford the trader options for its visual presentation. The calculations for the RSI are largely automated, providing a real-time representation of the indicator with no need for manual calculation. Charting platforms such as Trading Station, MetaTrader 4, and NinjaTrader provide charting functionality including RSI.
The RSI is a convenient method of labelling a security as being overbought or oversold. However, it is important that the trader remains mindful of market state and inherent volatility facing the product actively being traded. Trending markets, in addition to large periodic spikes in pricing volatility, can limit the capabilities and predictive value.
Ultimately, the RSI is most effective when utilised in concert with other aspects of technical and fundamental analysis.
FXCM Research Team
FXCM Research Team consists of a number of FXCM's Market and Product Specialists.
Articles published by FXCM Research Team generally have numerous contributors and aim to provide general Educational and Informative content on Market News and Products.
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