Relative strength index (RSI)

RSI stands for relative strength index. The RSI was developed by J Welles Wilder Jr as a momentum oscillator to measure the rate of change of price movements over a specific period. The default period used to calculate the RSI is 14 days, but weeks, months and intraday data can also be used. Traders interested in day trading and swing trading can consider shorter periods to calculate the RSI.

The RSI can be used in conjunction with other indicators. It provides important information that traders can use prior to entering a position.

The RSI indicator generates a measurement between zero and 100. According to Wilder, the RSI is overbought when the index has a reading above 70, and it is oversold when it has a reading below 30. In addition to overbought and oversold levels, the RSI can also introduce signals by looking for divergence, failure swings and centreline crossovers.

The RSI can also be used to identify trends​​. Very overbought and very oversold periods are defined at 80 and 20 respectively. The rate of change of price action can indicate if momentum is accelerating or decelerating. This is important as it can help traders determine the current trading environment and define which strategy to adopt. For example, many traders buy on a dip when negative momentum is decelerating and sell on a rally when positive momentum is decelerating.

Alternatively, you may want to buy on a breakout when positive momentum is accelerating, and sell on a breakdown when negative momentum is accelerating. The RSI will provide enough information to determine if the price of an asset is experiencing negative or positive momentum and whether that momentum is accelerating or decelerating.

The RSI is an index between 0 and 100. It is calculated by the following formula:

100 RSI = 100 - (100/1 + average gain / average loss)

The bulk of the calculation is determining the average gain, divided by the average loss. This is referred to as relative strength or RS. The default that Wilder determined is a 14-day period. This can be changed and used on all measures of time. Additionally, losses are expressed as positive values.

The index is easily calculated once the average gain and loss have been determined over a 14-day period. Since an average of the past 14-day period is needed, you would have to calculate the average gains and losses.

The RSI can be used in several ways to determine market trends. The most popular way of measuring market trends is to evaluate whether a security is overbought or oversold. This method employs a contrarian style of trading the market: one buys the dip because the proverbial rubber band has stretched too far too fast and is likely to bounce back.

Divergence occurs when momentum is moving in one direction, but prices are moving in another. In this scenario, prices would continue to slide or rally, but the RSI would fail to confirm that momentum is increasing in the direction of the trend. Decelerating momentum could indicate that the trend is about to consolidate.

This scenario could provide many types of trading opportunities. For example, in the Apple chart, the purple arrow shows a situation where prices hit a new lower low but the RSI does not make a lower low. Prices are still on the decline, but negative momentum has decelerated. The reverse could also occur, where prices are breaking out, but the RSI fails to make fresh highs. This reflects a situation where positive momentum is decelerating.

The RSI is an important technical analysis methodology and one that many traders will use as part of their trading strategy. It is a versatile technical analysis tool and is most effective when combined with another method. For example, it can be used in conjunction with Bollinger Bands to determine if a security is stretched too far. Support and resistance levels measured by moving averages or trendlines can also be used to find levels where the market is oversold and finds support, or overbought and finds resistance.

Open an account to get started trading with the RSI indicator. You will automatically be granted access to a free Sign Up, where you can practise with virtual funds.