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.
Calculating The RSI
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 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 loss, the total of 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.
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.
Applications Of The RSI
In 1978, technical analyst and trader 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 or divergence.
However, RSI does face a few challenges. 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. 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.
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 and MetaTrader 4 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.
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