Relative Strength Index
Relative Strength Index (RSI) is a commonly used momentum indicator developed by J. Welles Wilder to detect possible trend reversals. It oscillates between 0 and 100, and depending on the current reading of the indicator, speculations about the markets can be made.
The Relative Strength Index might connote a comparison between two securities, but it actually displays the force of a single security. This power gauge is especially sought-after by traders and investors because it produces the most accurate signposts in times of sideways or non-trending markets.
To work out the RSI, you can use the following formula:
Let us use this example to demonstrate it:
We can look at the situation with the stock priced at 99 on day 0 as a reference point, and then analyse the following information:
The data in the table shows the difference between today’s close and yesterday’s close. For example, if today’s close is 104 and the previous day’s was 100, the result is points gained equal to 4 and points lost equal to 0.
Alternatively, if today’s close is 104, but yesterday it was 107, then there would be 0 points gained and 3 points lost (with negative values being represented as positives).
We employed 14 data points for our calculations, which is also referred to as the ‘look-back period’. For hourly charts, this comes to 14 hours, while daily charts demand a 14-day period.
To work out ‘RS’, also known as the RSI factor, begin by computing the average points won against the average points lost.
Average Points Gained = 29/14
Average Points Lost = 10/14
RS = 2.07/0.714
Plugging in the value of RS in the RSI formula,
= 100 – [100/ (1+2.8991)]
= 100 – [100/3.8991]
= 100 – 25.6469
RSI = 74.3531
The RSI calculation is straightforward. The use of this index assists traders in recognizing market conditions that are either oversold or overbought. When a stock has an excessive amount of positive momentum, it’s likely that a correction will occur; this is known as being “overbought”. On the opposite side of the equation, if there is too much negative momentum, there could be a reversal; this is called “oversold”.
One last note
When analysing RSI, it’s important to approach parameters with flexibility. J.Welles Wilder used a 14-day lookback period in 1978 when introducing RSI to the world because that value gave the best results for the market at that time. However, traders may opt to use 5, 10, 20 or even 100 days instead. Finding what works best for you is how you gain an edge as a trader and should be your goal. Please keep in mind that fewer days are used to calculate the RSI means more volatility with the indicator.
J.Welles Wilder prescribed 0-30 and 70-100 as regions of oversold and overbought, respectively, but other combinations are possible.
Personally, I rely on 0-20 and 80-100 for identifying buying and selling points, respectively. Complementary to this, I use a classical fourteen-day lookback period.
I strongly suggest that you figure out what works best for you. Doing so will be key in your progression as a successful trader.
RSI is seldom used as a single indicator; it is normally employed in combination with other candlestick patterns and indicators to analyse the market.