Relative strength index: Meaning, Criticisms & Real-World Uses

Relative Strength Index

What Is Relative Strength Index?

The Relative Strength Index (RSI) is a momentum oscillator used in technical analysis that measures the speed and change of price movements. Developed by J. Welles Wilder Jr., the Relative Strength Index is displayed as an oscillator, a line graph that moves between two extremes, typically scaled from 0 to 100. It helps financial analysts and traders identify overbought or oversold conditions in the price of an asset, potentially signaling an impending trend reversal. The RSI provides insights into the strength of an asset's recent price performance, indicating how aggressively buyers or sellers are driving the market.

History and Origin

The Relative Strength Index was introduced by J. Welles Wilder Jr. in his seminal 1978 book, "New Concepts in Technical Trading Systems."⁵ Wilder, a mechanical engineer by training, transitioned to real estate development before dedicating his work to developing numerous technical analysis tools that are now considered foundational in the field. His book unveiled several indicators, including the Average True Range (ATR), Parabolic SAR, and the Average Directional Index (ADX), alongside the RSI. "New Concepts in Technical Trading Systems" provided specific calculation methodologies and interpretation guidelines for these indicators, which became widely adopted by traders seeking to understand market dynamics beyond traditional fundamental analysis.

Key Takeaways

The Relative Strength Index (RSI) is a momentum oscillator ranging from 0 to 100, designed to measure the speed and change of price movements.
Traditionally, an RSI reading above 70 suggests an asset is overbought, while a reading below 30 indicates it is oversold.
Traders use the RSI to identify potential trend reversal points, confirm market trends, and spot divergence between price and momentum.
The default and most common period for RSI calculation is 14, often applied to daily, weekly, or monthly price data.
While a popular tool, the RSI is typically used in conjunction with other chart patterns and indicators for more robust trading decisions.

Formula and Calculation

The Relative Strength Index is calculated in two main steps. First, the Relative Strength (RS) is computed, which is the ratio of the average gain to the average loss over a specified number of periods (usually 14). Second, the RS value is smoothed and scaled to produce the RSI.

The formulas are as follows:

RS = \frac{\text{Average Gain}}{\text{Average Loss}}

For the initial 14-period calculation:

\text{Average Gain} = \frac{\text{Sum of Gains over 14 periods}}{14}

\text{Average Loss} = \frac{\text{Sum of Losses over 14 periods}}{14}

For subsequent periods, a smoothing component is introduced:

\text{Average Gain}_t = \frac{(\text{Previous Average Gain} \times 13) + \text{Current Gain}}{14}

\text{Average Loss}_t = \frac{(\text{Previous Average Loss} \times 13) + \text{Current Loss}}{14}

Once RS is calculated, the final RSI value is determined using the following formula:

RSI = 100 - \frac{100}{(1 + RS)}

Where:

Gain refers to the upward price change on a given period.
Loss refers to the absolute value of the downward price change on a given period.
t denotes the current period.

The Average Gain and Average Loss are calculated separately. Periods where there is no gain or no loss are counted as zero for that specific component. The RS value is then used to normalize the index to a scale of 0 to 100.

Interpreting the Relative Strength Index

Interpreting the Relative Strength Index primarily involves observing its values relative to established thresholds, typically 70 and 30. An RSI reading above 70 traditionally suggests that an asset is overbought, meaning its price has risen too quickly and may be due for a correction or trend reversal. Conversely, an RSI reading below 30 indicates an oversold condition, implying that the asset's price has fallen excessively and could be poised for a rebound.

Beyond these basic levels, traders also look for divergence, which occurs when the price of an asset moves in one direction while the RSI moves in the opposite. For instance, if an asset's price makes a higher high but its RSI makes a lower high (a bearish divergence), it could signal waning upward price action and a potential bearish reversal. Conversely, a bullish divergence, where price makes a lower low but RSI makes a higher low, might suggest a potential upward reversal. The RSI can also help confirm the overall market trend; an RSI consistently staying above 50 during an uptrend or below 50 during a downtrend can indicate the strength of that trend.

Hypothetical Example

Consider a hypothetical stock, "GrowthTech Inc." (GTI), whose price has been steadily climbing. A trader is monitoring GTI using the Relative Strength Index with a 14-period setting.

Over the past few days, GTI's closing prices have been: Day 1: $50.00, Day 2: $51.50, Day 3: $52.75, Day 4: $52.00, Day 5: $53.50, Day 6: $54.25, Day 7: $55.00, Day 8: $55.75, Day 9: $56.50, Day 10: $57.25, Day 11: $58.00, Day 12: $58.75, Day 13: $59.50, Day 14: $60.25. (For simplicity, assume these are the first 14 periods for calculation.)

To calculate the initial RS and RSI:

Identify gains: Day 2 (+1.50), Day 3 (+1.25), Day 5 (+1.50), Day 6 (+0.75), Day 7 (+0.75), Day 8 (+0.75), Day 9 (+0.75), Day 10 (+0.75), Day 11 (+0.75), Day 12 (+0.75), Day 13 (+0.75), Day 14 (+0.75).
Identify losses: Day 4 (-0.75).
Sum of Gains = 1.50 + 1.25 + 1.50 + 0.75 + 0.75 + 0.75 + 0.75 + 0.75 + 0.75 + 0.75 + 0.75 + 0.75 = 11.25
Sum of Losses = 0.75
Average Gain = 11.25 / 14 = 0.8036
Average Loss = 0.75 / 14 = 0.0536
RS = 0.8036 / 0.0536 = 15.00
RSI = (100 - \frac{100}{(1 + 15.00)}) = (100 - \frac{100}{16}) = (100 - 6.25) = 93.75

An RSI of 93.75 for GTI suggests a highly overbought condition, indicating that the stock's recent price appreciation has been very strong and it may be vulnerable to a pullback. A trader might interpret this high RSI as a signal to consider taking profits or to avoid initiating new long positions, particularly if other indicators or trading strategies also suggest caution.

Practical Applications

The Relative Strength Index is a versatile tool with several practical applications in financial markets. Traders frequently use it to identify potential buying or selling opportunities. When an asset's RSI dips below 30, signaling an oversold condition, traders might view this as a potential entry point for a long position, anticipating a price rebound. Conversely, an RSI above 70, indicating an overbought state, could prompt traders to consider exiting long positions or initiating short positions.

Beyond simply identifying extreme conditions, the RSI is also employed to confirm market trend strength and detect divergence. For instance, a continued upward trend in a stock's price accompanied by an RSI that maintains levels above 50 reinforces the bullish momentum. Conversely, if a stock's price continues to make new highs but the RSI fails to reach new highs (bearish divergence), it can suggest weakening momentum and a potential trend reversal. Analysts also integrate RSI signals with other technical analysis tools, such as support and resistance levels or chart patterns, to build more comprehensive trading strategies. For example, a Reuters article noted analysts using RSI climbing above 70 as a sign of strong bullish momentum for a stock, while a bearish divergence in RSI was flagged as an early warning sign of exhaustion.⁴ This demonstrates how the RSI is a component of a broader analytical framework.

Limitations and Criticisms

While widely used, the Relative Strength Index is not without its limitations and criticisms. One common critique is that RSI signals, particularly the overbought and oversold levels, can be subjective and may not always lead to immediate trend reversals. During strong market trends, the RSI can remain in overbought territory (above 70) for extended periods in an uptrend, or oversold territory (below 30) in a downtrend, leading to premature exit or entry signals if used in isolation. This highlights that the indicator works best in trading range-bound markets rather than trending markets.

Furthermore, like all technical analysis indicators, the RSI is based on historical price action and does not incorporate fundamental factors, news events, or future market conditions. Critics argue that technical indicators, including the RSI, can be a form of "pseudoscience" and that their patterns are often only clear in hindsight³. Some academic perspectives, often rooted in the Efficient Market Hypothesis, contend that it is impossible to consistently profit from historical price data because all available information is already reflected in current prices.² While studies on the efficacy of the RSI exist, results can be mixed; for example, one study found that while combining RSI with fundamental analysis in certain markets outperformed a benchmark, the annualized returns were modest.¹ Therefore, effective risk management dictates that the RSI should be used as one piece of a larger analytical puzzle, often alongside other indicators and fundamental analysis, rather than as a standalone predictor of market movements.

Relative Strength Index vs. Moving Average Convergence Divergence

The Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD) are both popular momentum oscillators used in technical analysis, but they measure momentum in different ways and often provide complementary insights.

Feature	Relative Strength Index (RSI)	Moving Average Convergence Divergence (MACD)
Calculation Basis	Measures the speed and change of price movements by comparing average gains and losses.	Measures the relationship between two exponential moving averages (EMAs) of an asset's price.
Scale	Oscillates between 0 and 100.	Oscillates above and below a zero line, with no fixed upper or lower bounds.
Primary Use	Identifying overbought (above 70) and oversold (below 30) conditions.	Identifying trend direction, momentum, and potential trend changes through crossovers with its signal line and zero line.
Signals	Overbought/Oversold levels, divergence, and centerline (50) crossovers.	MACD line and signal line crossovers, zero line crossovers, and divergence between MACD and price.
Sensitivity	Can be more sensitive to sudden price changes, as it focuses on relative strength.	Tends to be smoother due to its reliance on moving averages, which can sometimes result in slightly lagged signals.

While the RSI focuses on the rate of price change, providing insight into the magnitude of recent gains versus losses, the Moving Average Convergence Divergence focuses on the relationship between different moving averages to signal shifts in momentum and trend. A trader might use RSI to spot potential reversals from extreme price conditions, and then use MACD to confirm the new trend direction once it has begun to form.

FAQs

What is a good RSI reading?

There isn't a universally "good" RSI reading, as interpretation depends on context. However, traditional wisdom suggests an RSI above 70 indicates an overbought asset that may be due for a pullback, while an RSI below 30 suggests an oversold asset that may be due for a rebound. Readings between 30 and 70 are generally considered neutral, with a move towards 50 indicating increasing momentum in the direction of the market trend.

Can RSI be used for all types of assets?

Yes, the Relative Strength Index can be applied to various financial assets, including stocks, commodities, currencies (Forex), and cryptocurrencies. It is a technical analysis tool that analyzes price data, making it applicable to any asset with sufficient price history.

What is RSI divergence?

RSI divergence occurs when the price of an asset and its RSI move in opposite directions. A bullish divergence happens when an asset's price makes a new lower low, but the RSI makes a higher low, suggesting weakening downward momentum and a potential trend reversal upwards. A bearish divergence occurs when the price makes a new higher high, but the RSI makes a lower high, indicating weakening upward momentum and a potential downward reversal.

How often should I check the RSI?

The frequency of checking the Relative Strength Index depends on your trading strategies and time horizon. Short-term traders or day traders might monitor RSI on intraday charts (e.g., 5-minute or 15-minute), while swing traders or long-term investors might use daily, weekly, or even monthly charts. The shorter the timeframe, the more signals the RSI will generate, but these signals may also be less reliable.