146

What is RSI Indicator? | Relative Strength Index Explained

What is RSI Indicator? | Relative Strength Index Explained | Beginner’s Guide
Diana
Paluteder
2 weeks ago
12 mins read

The following guide will examine the relative strength index (RSI), what it is and what it measures, how to understand the indicator on charts and interpret those findings, as well as the pros and cons of using this technical analysis tool. 

What is the RSI indicator?

The relative strength index (or RSI) is a popular technical analysis tool used in stock trading that indicates momentum by measuring the speed and change of price movements to assess overvalued or undervalued conditions in the price of that asset. 

The RSI is displayed as an oscillator, i.e., a line graph on a scale of zero to 100. It was developed by J. Welles Wilder Jr. and explained in detail in his 1978 book, “New Concepts in Technical Trading Systems.”

The momentum oscillator can demonstrate overbought and oversold conditions, as well as point to a general trend or securities that may be primed for a trend reversal or corrective pullbacks in price. Traders typically interpret the RSI line moving below the overbought line or above the oversold line as a signal to buy or sell


Beginners’ corner:


How does the RSI indicator work?

The RSI is usually based on a 14-day time frame, but this can be lowered to increase sensitivity or raised to decrease sensitivity. For example, 10-day RSI is more likely to reach overbought or oversold levels than a 20-day RSI. 

Generally, an RSI reading of 70 or above indicates overbought conditions. Conversely, a reading of 30 or below points to an oversold situation. However, these traditional levels can be altered to fit the particular security better. For instance, if the security is repeatedly reaching the overbought level of 70, you may want to alter this level to 80.

Knowing the asset’s primary trend is crucial for understanding RSI readings correctly. For example, as proposed by Constance Brown in “Technical Analysis for the Trading Professional,” an oversold reading in an uptrend is possibly much higher than 30. Similarly, an overbought reading during a downtrend is much lower than 70. 

Many investors create a horizontal trendline (a line drawn over the highs and under the lows to create a channel) between 30 and 70 when a strong trend is in place to identify the overall trend and extremes better.

However, modifying overbought or oversold RSI levels when the price of a security is in a long-term horizontal channel instead of a solid upward or downward trend is usually unnecessary.

The RSI is not as reliable in trending markets as in trading ranges. In fact, most traders accept that the signals given by the RSI in strong upward or downward trends often can be false.

Note: Traders should use the RSI with other technical indicators to help make better-informed trading decisions.

Recommended video: How to use the relative strength index (RSI)?

The RSI calculation

The RSI uses a two-part calculation. First, it is required to calculate the relative strength (RS), which equals the average gain divided by the average loss:

RS = Average Gain / Average Loss

Then, once there are 14 (the standard number of periods recommended by Wilder) periods of data available, the second calculation can be made. The formula is as follows:

RSI = 100 – (100 / (1+RS))

Example RSI calculation

For example, during a 14-day trading period, let’s assume that stock ABC has generated positive returns on nine days with an average gain of 2% and negative returns on five days with an average loss of 1%. Then, plugging those figures into the two formulas, we get:

RS = 0.02 / .01 = 2

RSI = 100 – 100 / (1 + 2) = 66.67

Note: Do not confuse RSI and relative strength (RS). The former refers to changes in the price momentum of one security. The latter compares the price performance of a security to the market as a whole or to a relevant benchmark.

How to use the RSI indicator?

Traders can use the RSI indicator to:

  • Predict the price behavior of an asset;
  • Validate trends and trend reversals;
  • Point to overbought and oversold securities;
  • Identify buy and sell signals;
  • Develop a trading strategy in conjunction with other technical analysis tools.

Note: Technical analysis patterns depict past price movement only. Using past price fluctuations to predict future price action involves a high level of risk. Therefore, investors should refrain from making investment decisions based solely on technical indicators. 

RSI buy and sell signals

RSI buy and sell signals can be determined by:

  1. Identifying overbought and oversold conditions;
  2. RSI divergence indicator;
  3. Positive and negative RSI reversals;
  4. Swing rejections;
  5. Interpreting RSI ranges.

1. Identifying overbought and oversold conditions

Typically, an RSI less than 30 is considered a bullish sign, while RSI above 70 is regarded as a bearish sign. Additionally, when the RSI indicator crosses 70 on the RSI chart, it indicates that an asset is becoming overbought or overvalued, i.e., it may be primed for a trend reversal or corrective price pullback. Conversely, an RSI of 30 or below suggests an oversold or undervalued condition.

How RSI signals overbought or oversold conditions. Source: Museumxaser.weebly.com

Overbought describes a period with a significant and consistent upward movement in price over time without much pullback. It is a term used when an asset is believed to trade at a price beyond its intrinsic value, meaning it’s priced above where it should be according to technical and fundamental indicators. Overbought conditions may indicate a price correction or trend reversal and signal traders to exit (sell) a position.

On the other hand, oversold defines a period with a substantial and consistent downward move in price over time without much pullback. The term refers to a condition where a security has traded well below its typical value metrics and has the potential for a price bounce. Similarly, oversold conditions may indicate a price correction or trend reversal and signal traders to enter (buy) a position. 

Note: Sometimes, the RSI can stay overbought or oversold for a while, so traders should defer from picking a top or a bottom of a strong move that continues to advance into further overbought or oversold territory. In other words, it is essential to wait until the RSI crosses back under 70 or back above 30.

For example, suppose a trader witnesses the RSI breaking above 70, indicating overbought conditions. In that case, they shouldn’t immediately sell their positions because they don’t know how far the price could rally. Instead, they should wait until the RSI falls back below 70 and then place their sell trade. This provides the trader with a better entry and a higher probability trade.

The same rules apply in oversold conditions. Traders should wait until the RSI crosses back above 30 before they place a buy trade.

2. RSI divergence indicator

Divergences occur when the price moves in the opposite direction of the RSI, i.e., a chart might indicate a change in momentum before a corresponding price change.

A bullish divergence occurs when:

  • The price chart displays prices falling to lower lows, signified by a downward-sloping line connecting the lows;
  • The RSI chart displays an oversold reading followed by lows moving higher, signified by an upward-sloping line connecting the lows.
Bullish divergence RSI chart. Source: Thinkmarkets.com

Together, these two conditions indicate rising bullish momentum, and a break above oversold territory could be used to trigger a new long position.

A bearish divergence occurs when:

  • The price chart displays highs moving higher, signified by an upward-sloping line connecting the highs;
  • The RSI chart displays an overbought reading followed by highs moving lower, signified by a downward sloping line connecting the highs.
Bearish divergence RSI chart. Source: Thinkmarkets.com

Together, these two conditions indicate rising bearish momentum.

Note: Divergences can be rare when an asset is in a steady long-term trend. So, utilizing oversold or overbought readings will help determine additional signals.

3. Positive and negative RSI reversals

Another price-RSI relationship that traders look for is positive and negative RSI reversals. Positive and negative reversals are the opposite of bearish and bullish divergences.

For example, a positive RSI reversal may occur if the RSI reaches a low that is lower than its previous low, simultaneously with the asset’s price reaching a low that is higher than its previous low price. Such a formation is viewed as a bullish sign and, thus, a buy signal for traders.

Positive reversal on a chart. Source: School.stockcharts.com

Negative RSI reversal, on the other hand, may occur once the RSI reaches a high that is higher than its previous high at the same time that the asset’s price reaches a lower high. Such a formation is considered a bearish sign and, therefore, a sell signal for traders.

Negative reversal on a chart. Source: School.stockcharts.com

4. Swing rejections

Unlike RSI divergences and positive-negative reversals, swing rejections or failure swings are independent of price action, focusing solely on RSI for signals.

A bullish failure swing forms when:

  1. The RSI drops into oversold territory (below 30);
  2. The RSI bounces back above 30;
  3. The RSI establishes another dip without moving back into oversold territory;
  4. The RSI then breaks its prior high.

Using the RSI in this particular way is very similar to drawing trend lines on a price chart.

Bullish failure swing signal. Source: School.stockcharts.com 

The bearish failure swing forms when:

  1. The RSI climbs into overbought territory (above 70);
  2. The RSI drops back below 70;
  3. The RSI establishes another high without moving back into overbought territory;
  4. The RSI then breaks its prior low.

As with most trading strategies, this signal will be most reliable when it follows the long-term trend. In addition, bearish signals during downward trends are less likely to provoke false alarms.

Bearish failure swing signal. Source: School.stockcharts.com

5. Interpreting RSI ranges

RSI readings may fall into a range during trends. For example, during an uptrend, the RSI is likely to stay above 30 and should frequently hit 70. On the other hand, during a downtrend, it is rare to see the RSI exceed 70; instead, the indicator frequently hits 30 or below.

These guidelines can help traders determine trend strength and spot potential reversals. For example, if the RSI can’t reach 70 on several consecutive price swings during an uptrend but then drops below 30, the trend has weakened and could be reversing lower. 

Conversely, if the downtrend cannot reach 30 or below and then rallies above 70, that downtrend has weakened and could be reversing to the upside. Remember, both trend lines and moving averages are helpful technical tools to include when using the RSI in this way.

Pros and cons of RSI

Like with most other technical indicators, the relative strength index, too, comes with its own set of unique benefits and limitations. Therefore, it’s crucial to understand where this particular momentum indicator triumphs and where it fails to get the most out of its use.

Pros

  • Applicable to any market and timeframe;
  • Helps to detect potential entry (buy) and exit (sell) points;
  • Gives an overview of general price movement, trends, and trend reversals;
  • Straightforward setup;
  • Relatively easy to evaluate and gain needed information;
  • Helpful as a stand-alone tool or in combination with other technical indicators.

Cons

  • Because the RSI is measuring momentum, it can remain in the overbought or oversold territory despite trend reversals already taking shape. Therefore, the RSI is most functional in an oscillating market (a market that repeatedly moves back and forth) where the asset price alternates between bullish and bearish movements;
  • Accurate reversal signals are rare and can be challenging to separate from false alarms; 
  • RSI signals are most reliable when they conform to the long-term trend;
  • Fundamental data and trading volume data are not taken into account;
  • Traders should apply the RSI together with other technical indicators for the most accurate trading signals. 

In conclusion 

To sum up, the RSI measures the speed of an asset’s price changes and is used in technical analysis as a momentum indicator. As a result, it can be a powerful tool for determining trend reversals. However, because the RSI works best in oscillating markets rather than trending markets, it cannot tell investors exactly when those reversals will take place and what those price changes will be. 

Additionally, the RSI is likely to generate false signals and should thus be used in conjunction with additional technical analysis tools rather than as a standalone source of trading signals.

FAQs about the RSI indicator

What is the RSI indicator?

The RSI indicator is a momentum indicator used in technical analysis that measures the speed of an asset’s price changes. It provides traders with signals about bullish and bearish price momentum and is typically plotted under the security’s price graph.

How to read the RSI indicator?

A security is considered overbought when the RSI reading is above 70 and oversold when it is below 30. Traders generally interpret the RSI line moving below the overbought line or above the oversold line as a signal to buy or sell. 

What does the RSI tell you?

The primary function of the RSI is to demonstrate overbought and oversold conditions. However, it can also point to a general trend, a trend reversal, or corrective pullbacks in price. 

What are the RSI limitations?

Like most technical indicators, its signals are most reliable when they conform to the long-term trend. Unfortunately, accurate reversal signals are rare and can be challenging to separate from false alarms. 

Since the RSI is measuring momentum, it can remain in the overbought or oversold territory despite trend reversals already taking shape. Therefore, it is most trustworthy in an oscillating market when the price alternates between bullish and bearish periods rather than in trending markets. 

Be first to rate

Latest News

Join us on Twitter or Telegram

Or follow us on Flipboard Flipboard

Like the article? Vote up or share on your social media

Recommended content

Weekly Finance Digest

By subscribing you agree with Finbold T&C’s

Diana Paluteder
Author

Diana is an economics enthusiast with a passion for politics and investing. Having previously worked as a financial translator, she provides in-depth articles and guides on the world of finance and commerce.

AD