Relative Strength Index RSI Analysing Overbought and Oversold Signals to Boost Your Trading Strategy

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Marketopedia / Technical Analysis / Relative Strength Index RSI Analysing Overbought and Oversold Signals to Boost Your Trading Strategy

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

= 2.07

Average Points Lost = 10/14

= 0.714

RS = 2.07/0.714

= 2.8991

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”.

  1. If the RSI is stuck in an overbought position for an extended period, search for buying options instead of attempting to shorten it. This prolonged standing is due to an excess positive momentum.
  1. If the RSI has stayed in an oversold region for some time, it is likely due to an excess of negative momentum indicating potential selling opportunities rather than buying.
  1. If the RSI value begins to move away from the oversold reading after a length of time, it could be an indication of entering a buy position. This is particularly so when the indicator goes beyond 30 after a prolonged period, as this may suggest that the stock has potentially achieved its lowest point and, therefore, could call for going long.
  1. If the RSI value begins to drift away from the overbought indicator after an extended period of time, it may be a good idea to look for selling opportunities. As an example, if the RSI drops beneath 70 after having been overbought for a while, it could indicate that the stock has hit its peak and therefore provide grounds for shorting.

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.