Relative Strength Index (RSI): Explanation, Formula, and Analysis

The Relative Strength Index (RSI) is a widely-used momentum indicator in technical analysis. It measures the speed and change of price movements, helping investors and traders assess whether a stock or other asset is overbought or oversold.

Formula

The RSI is calculated using the following formula:

Where:

• \(RS\) (Relative Strength) = \(\frac{\text{Average Gain}}{\text{Average Loss}}\)

The typical look-back period for RSI is 14 days, although this can be adjusted to suit different trading strategies.

Example Calculation

Assume the following price changes over a 14-day period:

• Gains: $8, $6, $7, $5, $10, $3, $6, $8
• Losses: $4, $3, $2, $4, $5, $6

The average gain = \(\frac{8+6+7+5+10+3+6+8}{14}\)

The average loss = \(\frac{4+3+2+4+5+6}{14}\)

Relative Strength (RS) = \(\frac{\text{Average Gain}}{\text{Average Loss}}\)

Substitute RS into the RSI formula to get the RSI value.

Interpretation of RSI Values

• RSI values range from 0 to 100.
• An RSI above 70 often indicates that an asset is overbought.
• An RSI below 30 often indicates that an asset is oversold.

Overbought and Oversold Conditions

Traders use RSI to identify potentially profitable points:

• Overbought: When RSI is above 70, it may signal that the asset is overpriced and could undergo a downward correction.
• Oversold: When RSI is below 30, it may signal that the asset is underpriced and could experience a price increase.

Divergences

• Bullish Divergence: Occurs when price hits a new low, but RSI forms a higher low.
• Bearish Divergence: Occurs when price hits a new high, but RSI forms a lower high.

Related Terms

• Stochastic Oscillator: Another technical indicator for comparing the closing price of a security.
• MACD (Moving Average Convergence Divergence): Used to identify changes in the strength, direction, momentum, and duration of a trend.
• Bollinger Bands: A method for pricing volatility.

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