The Relative Strength Index, or RSI, is a momentum indicator that depicts the price momentum of the stock you are trading.
Introduced by J. Welles Wilder Jr. in his 1978 classic, New Concepts in Technical Trading Systems
Essentially RSI shows the ratio of price movement on days the stock price rises as compared with price changes on days the stock price falls. It then normalizes these gains by forcing the index to hold between a level of “0″ and “100.”
The formula used to calculate RSI is as follows:
RSI = 100 – [100/(1+RS)]
Where,
RS = Average of up day’s closes / Average of down day’s closes
This average is determined by summing up the total price gains on up days and dividing by how many total price changes you are examining. For the down average, add up the absolute value of the changes on the days prices fell, and then divide that figure by the total number of price changes.
For example, if I compute RSI using 11 days of prices, I will then have 10 price changes. If the sum of the gains on the up days is $1.50 and the sum of the losses on the down days is $1.00, then the RSI calculation would look something like this:
Average of up prices = $1.50/10 = 0.15
Average of down prices = $1.00/10 = 0.10
RS = .15/.10 = 1.5
RSI = 100 – [100/(1+1.5)] = 60
OVERBOUGHT AND OVERSOLD
RSI is often used as a way of determining when something is overbought or oversold. The term “overbought” is supposed to mean that the stock you are tracking is at risk of reversing lower, at least for a correction, because its price has risen too far, too fast. Meanwhile, “oversold” stocks are supposedly in position to reverse higher because their prices have fallen too far, too fast.
RSI offers you one way of quantifying overbought and oversold. When I’m using a 14-day RSI, then I generally consider the 70 level to be overbought and the 30 level to be oversold. If I use an 8-day measure, then I would use 75 or 80 for overbought and 20 or 25 for oversold, as the smaller the number of days, the more volatile the RSI indicator will be.
Keep in mind that these “rules of thumb” will probably get you into a whole lot of trouble. RSI is what is known as a “momentum oscillator.” If you attempt to use the indicator to sell when momentum is high or buy when it is low, you may very well be trading against the trend. By definition, the market will tend to be overbought in a strong uptrend and oversold in a strong downtrend. Buying and selling at oversold and overbought levels works only in a range bound or non-directional market.
Some traders will still try to sell when RSI gets high or buy when it is very low. However, they will adjust for the market’s overall trend. For example, if the trend is up, then many traders will only sell when RSI moves above, then falls below, the 80 mark. If the trend is up, they will buy if RSI falls below and then moves back above 40. Likewise, in a bear market (read trending down), they will often buy only when RSI drops below and then moves back above 20 and will sell on a move above, and then back below, 60. (Note: All of these levels are based on a 14-day RSI measure.) Personally I find that RSI is better if used to assist in making a sell decision and not so much on a buy decision. When RSI falls below 70 (or 80 in bull market) then I think this is one sell signal, which I would act on only if confirmed by other indicators (full stochastic, MACD, volume analysis, trend line analysis, etc).
Another great use for RSI is when a divergence occurs. Divergences are often a warning of an impending change in trend. For example if the stock you’re examining is in an uptrend, then a divergence occurs when prices reach a new high, but RSI does not. If the stock you’re examining is in a downtrend, then a divergence occurs if prices fall to a new low, but RSI does not manage a new low. When this occurs it is warning you that a trend reversal may be immanent.
In the example above notice how the stock price is reaching new highs yet the RSI is not following suite. This is called negative divergence. Of course only time will tell if the stock will reverse, but based on this indicator it certainly looks like a drop in price is coming. The next step would be to confirm your ideas with other indicators.
A word of warning: RSI is only one of several indicators that should be examined. You should not base your buying and selling decision on only one indicator. Wait until at least two and preferably three different indicators give you the same signal before acting.
SUMMARY
The Relative Strength Index (RSI) is one of the most widely used technical indicators. It is well suited as part of a computer-based trading system. However, blindly following the crowd by selling when the market is overbought, or buying when it is oversold, is a strategy that is nearly guaranteed to lose you money in the long run.
