The Relative Strength Index (RSI) is a momentum oscillator used in technical analysis to measure the speed and change of price movements. Developed by J. Welles Wilder in 1978, it is commonly used to evaluate whether an asset is overbought or oversold, which can indicate potential reversal points in the market.
Calculation: The RSI is calculated using the following formula:
- RSI=100−(1001+RS)RSI = 100 - \left(\frac{100}{1 + RS}\right)RSI=100−(1+RS100)
where RS (Relative Strength) is the average of X periods' (usually 14) closing prices of up days divided by the average of X periods' closing prices of down days.
- RS = Average GainAverage Loss\frac{\text{Average Gain}}{\text{Average Loss}}Average LossAverage Gain
- Average Gain = (Sum of all gains over the past 14 periods) / 14
- Average Loss = (Sum of all losses over the past 14 periods) / 14
Interpretation:
- Overbought Condition: RSI above 70 typically indicates that the asset is overbought, meaning it may be overvalued and could be due for a price correction or pullback.
- Oversold Condition: RSI below 30 typically indicates that the asset is oversold, meaning it may be undervalued and could be due for a price rebound.
- Neutral Condition: RSI around 50 suggests a balance between buying and selling pressures.
Use in Trading:
- Divergence: If the price of an asset makes a new high or low that isn't confirmed by the RSI, it can signal a potential reversal. For instance, if the price makes a new high but the RSI doesn't reach a new high, it could indicate weakening momentum and a possible downturn.
- Failure Swings: This occurs when the RSI moves beyond a previous high (for bullish signals) or low (for bearish signals) and then reverses direction.
- Trend Identification: Some traders use RSI to confirm trends. For example, in an uptrend, RSI tends to remain above 30 and frequently hits 70, while in a downtrend, it often stays below 70 and frequently hits 30.
If you're analyzing a stock and notice that its RSI has crossed above 70, you might consider it a signal to prepare for a potential sell or to tighten your stop-loss orders. Conversely, if the RSI falls below 30, it might be a signal to consider buying or to prepare for a potential upward reversal.