Relative Strength Index

Updated on April 17, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Relative Strength Index (RSI)?

The relative strength index (RSI) refers to a momentum indicator that analyses the pace and variation of price movements. The value of RSI ranges from 0 to 100. Its purpose is to track price momentum changes. When the RSI of a security is above 70, it is considered overbought; it is deemed over sold when it is less than 30.

What Is Relative Strength Index (RSI)

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The Relative Strength Index is a technical indicator primarily used in the financial markets. For example, the relative strength Index in the stock market gives buying or selling signals to investors. In technical analysis, it is used to detect a broad trend, failure swings, divergences, double tops/bottoms, and crossover in the market.

Key Takeaways

  • RSI is a momentum oscillator determining the pace and variation of security prices.
  • The index signals purchase when it falls below 30 and reaches the oversold region. When the RSI hits the overbought zone (>70), it signals to sell (or hold if you are keeping it as a long-term investment).
  • RSI is calculated using the formula RSI = 100 – (100 / [1 + {14-Day Average Gain / 14-Day Average Loss}])
  • It can create chart patterns that are not visible on the price chart, like trend lines or double tops/bottoms.

RSI Indicator Strategy Explained

The relative strength index meaning maps security or the financial market‘s strength or weakness depending on its trading history. American mechanical engineer J. Welles Wilder first introduced the concept in 1978. He proposed determining the mean of gains and losses to get bullish or bearish signals and discovering the optimal trading time. He then suggested a 14-day window. This input value has remained popular, but since then, the nine-day and 25-day RSIs have also grown in popularity.

RSI represents the price momentum. It indicates the best time to sell and purchase security using the 70-30 trigger method. The RSI above 70 is considered overbought, and below 30 is considered oversold. In other words, if the average gain exceeds the average loss, it signals a potential decline in the market. However, one can change these levels based on the security situation. For example, if a security’s overbought level of 70 is consistently reached, it can be raised to 80.

RSI usually stays in the range of 40-90 during an upward or bull market. Here, the range of 40 to 50 serves as support. Conversely, it remains in the range of 10-60 during a downward or bear market, with resistance in the range of 50 to 60. Factors like RSI parameters, the investment trend, and the market determine these ranges.

The RSI may stay in the overbought or oversold territory during strong moves. It can also create chart patterns not visible on the price chart, like trend lines or double tops/bottoms. Investors should watch for resistance or support on RSI as well.

This relative strength index divergence shows a price reversal due to a new increase or decrease in prices that the RSI does not corroborate. A Top Swing Failure results from a lower high below the prior low established by the RSI. Conversely, a Bottom Swing Failure results from a higher low above a previous high established by the RSI.

Chart And Interpretation

The following Bitcoin US/Dollar chart gives a clear idea about the RSI indicator.

Source

In the above chart, the RSI is denoted by the line below the candlesticks. As one can observe, on December 7, 2017, the RSI value was above 80, indicating oversold conditions. Around that level, the price level dropped significantly. Then, on February 5, 2017, the RSI value was below 30 (around 27), signaling oversold conditions. Around that level, the price went into an uptrend as the bulls drove up the price.

If one wishes to look at more of such charts to further develop their understanding of this indicator, they can visit the official TradingView website.

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RSI Formula

The RSI formula can be calculated using the mean changes in closing prices for a certain period.

First, relative strength (RS) is calculated as –

= Umean / Dmean.

Where,

Umean = mean of all the upward movement of prices of the last N bars (N = duration of RSI)

Dmean = mean of all the downward movement of prices of the last N bars (N = duration of RSI)

After that, RSI is calculated using the following formula:

RSI = 100 – (100/[1 + {14-Day Average Gain/14-Day Average Loss}])

Calculation Of RSI

One needs to compute the following components first before calculating RSI:

  1. Value of U and D
  2. Average upward and downward movement
  3. Value of relative strength
  4. The final value of RSI

Let us understand the working of the RSI formula and computation by taking the example of a security ABC an example:

  1. Collect data on the closing price of ABC over the previous 15 days
  2. Compute percentage change of daily prices
  3. & D) Following the daily percentage change calculation, record losses and profits in distinct columns daily
  4. &F) Compute the 14-day average by calculating the average gains and losses for the data of the previous 14 days
  5. Determine the relative strength of the asset by dividing the average gain by the average loss over the previous 14 trading days
  6. Finally, enter the relative strength data into the formula

RSI = 100 – (100 / [1 +RS ])

RSI = 100 – (100 / [1 +1.06 ])

= 100-(100 /2.06)

= 100-48.54

= 51.46

Dateclosing price (A)percent change (B)Gain (C)Loss (D)the average gain of 14 daythe average loss of 14 dayRelative strengthRSI
2/1/2021529.08       
2/2/2021538.161.721.720    
2/3/2021529.45-1.6201.62    
2/4/2021542.162.42.40    
2/5/2021551.791.781.780    
2/6/2021545.92-1.0601.06    
2/7/2021560.072.592.590    
2/8/2021562.590.450.450    
2/9/2021552.59-1.7801.78    
2/10/2021550.52-0.3700.37    
2/11/2021580.285.415.410    
2/12/2021578.12-0.3700.37    
2/13/2021546.22-5.5205.52    
2/14/2021541.22-0.9200.92    
2/15/2021530.78-1.9301.931.020.971.0651.45631
2/16/2021542.592.232.2301.060.971.0952.15311
2/17/2021540.52-0.3800.381.060.881.254.54545
2/18/2021590.289.219.2101.550.881.7663.76812
2/19/2021568.12-3.7503.751.421.151.2455.35714
2/20/2021556.22-2.0902.091.421.221.1653.7037
2/21/2021544.22-2.1602.161.231.380.947.36842
2/22/2021530.78-2.4702.471.21.550.7743.50282
2/23/2021571.127.67.601.751.431.2254.95495
2/24/2021556.22-2.6102.611.751.591.152.38095
2/25/2021545.22-1.9801.981.361.730.7944.13408
2/26/2021538.78-1.1801.181.361.780.7643.18182

The table shows that using the strategy of trend confirmation (Midline Analysis), security ABC has a value of RSI > 50 and RSI < 50. Therefore, it implies that it is bullish and bearish on some days.

Example

A recent article by NASDAQ analyses Schneider Electric shares to illustrate the application of RSI. After trading as low as $120.06 per share, shares of Schneider Electric (SBGSF) reached oversold territory, measured by an RSI reading of 29.6. The RSI value of the S&P 500 ETF (SPY) is 36.6 as of June 21, 2022. A bullish investor might interpret an RSI reading of 29.6 for SBGSF as a sign that the recent strong selling is exhausted and begin looking for entry point possibilities on the long side.

Shares of Schneider Electric, trading as BGSF, hit oversold territory on June 21, 2022, after falling to a price of $120.06 per share, as indicated by an RSI reading of 29.6. On the other hand, the S&P 500 ETF (SPY) indicates an RSI value of 36.6. Comparing these two readings, an investor may consider an RSI value of 29.6 as a buying signal resulting from the increase in the strong selling.

How To Interpret Relative Strength Index?

The upper-level U and the lower-level L will be read as follows when the benchmark period for RSI is 14 days:

Any asset above the level of the RSI (70) is overbought. It will indicate a turn away from the upward price trend and toward the downward trend. The trader must sell the stock immediately to benefit; otherwise, one would incur a loss.

Any security below this RSI (30) level will be oversold. As a result, it will signal a reversal in the declining trend of the security price and cause a surge in its pricing. As a result, at this point, the signal of buying the security for profit can be interpreted, and any continued holding of the security could be adverse to profits.

Simply put, when the RSI falls below 30 and reaches the oversold region, it is a good moment to purchase. When the RSI hits the overbought zone (>70), it’s a good opportunity to sell (or hold if you are keeping it as a long-term investment). Look at the relative strength Index chart given below; it highlights buying potential in red and selling potential in green.

Interpret Relative Strength Index

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It may enhance trading methods by informing entry and exit point decisions. However, as with most technical indicators, their indications are most accurate when they correspond to an extended trend.

The RSI will increase as the number and size of positive closures increase and decrease as the number and size of negative closes increase. The RSI is shown on a line graph that oscillates between two extremes) with a range of 0 to 100.

Frequently Asked Questions (FAQs)

What is a good Relative Strength Index?

Historically, an RSI of 30 or below is believed to be a good signal for buying as it indicates an oversold position. On the other hand, an RSI of 70 or above is considered suitable for selling the position.

What is relative strength index in stocks?

RSI signals investors regarding the trend of the stock price. It is also used to discover trend reversals in stock prices. RSI has a look-back duration of 14 days and an oscillation range of 0 to 100, indicating price variations in stocks.

How to use relative strength index?

The value of RSI oscillates from 0 to 100, with a value over 70 indicating the oversold condition and below 30 indicating the oversold condition. For a robust strategy, most traders combine RSI with other indicators, such as exponential moving averages and relatively short-term moving average crossings.

This has been a guide to What is Relative Strength Index & its meaning. We explain its formula, calculation, example, and interpretation. You can learn more about accounting from the articles below –

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