What is the Relative Strength Index or RSI?
Quick Take
The Relative Strength indicator was developed in 1978 by Welles Wilder.
It is an oscillator indicator that moves between the extreme values of 0 and 100.
The formula for RSI divides the average gain that price achieves over a specific time period by the average loss it has sustained and then plots the result on a scale from 0 to 100.
The classical use is to buy below 30 and sell above 70 but research shows this is an ineffective strategy.
RSI measures price momentum and therefore stocks with high RSI continue to rise. Similarly stocks with low RSI continue to underperform.
Momentum traders are therefore only interested in RSI levels 10-20 units above or below the mid-line or centre line at 50.
History of RSI
The Relative Strength Index (RSI) is a technical analysis indicator developed in the late 1970s as a trading tool. It is a momentum oscillator that measures the magnitude of price movements as well as the speed (momentum) of these movements.
The Relative Strength Index indicator was created by J. Welles Wilder in 1978 and presented in his book New Concepts in Technical Trading Systems, along with other technical analysis indicators, such as the Parabolic SAR, the Average True Range (ATR), and the Average Directional Index (ADX).
Before becoming a technical analyst, Wilder worked as a mechanical engineer and real estate developer. He started trading stocks around 1972 but wasn't very successful. A few years later, Wilder compiled his trading research and experience into mathematical formulas and indicators that were later adopted by many traders around the world. The book was produced in only six months, and despite being written in the 1970s, it is still a reference work for many chartists and traders today.
How does the RSI indicator work?
By default, the RSI measures the changes in an asset's price over a specified number of time periods. The formula divides the average gain the price has had over that time by the average loss it has sustained and then plots data on a scale from 0 to 100. Therefore at 0 the average gain is zero and at 100 the average loss is zero but these extreme values are rarely met.
The default setting for RSI is 14 periods i.e. 14 days on daily charts, 14 hours on hourly charts, and so on. This is written as RSI(14) with the period length in brackets. However traders may choose to modify it in order to increase sensitivity (fewer periods) or decrease sensitivity (more periods). Accordingly, a 7 day RSI is more sensitive to price movements than one that uses 21 days.
Interpretation of the RSI indicator
RSI is a price momentum indicator which measures the rate at which price is changing. When momentum increases and the price is rising, it indicates that the asset is being actively bought in the market. If momentum increases to the downside, it is a sign that the selling pressure is increasing.
The RSI is called an oscillating indicator because it swings between 0 and 100 which makes it easier for traders to spot overbought or oversold market conditions. While an RSI score of 30 or less suggests that the asset is probably close to its bottom (oversold), a measurement above 70 indicates that the asset price is probably near its high (overbought) for that period.
Short term day trading setups may use the 80/20 levels to avoid false signals.
However, there’s no guarantee of a trend reversal at extreme RSI values. In the 1930s, economist John Maynard Keynes said: “Markets can stay irrational longer than you can stay solvent." Unfortunately, that bit of wisdom remains true today.
The RSI centre line
For RSI, the centre line at 50 acts as a very important level to indicate the price direction. Typically price continues to stay above the mid 50 line during the bullish phase while it faces strong resistance from the 50 line in RSI during the bearish phase of the market.
Closing thoughts on RSI
There are several important factors to consider when using the Relative Strength Index indicator, such as the settings, the score (30 and 70), and the bullish/bearish divergences. However, one should always keep in mind that no technical indicator is 100% efficient - especially if it is used alone. Therefore, traders should consider using the RSI indicator along with other indicators in order to avoid false signals.
Useful Stuff
Download your RSI indicator HERE
Download a copy of Welles Wilder's "New Concepts in Technical Trading Systems" HERE
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