Technical analysis tool: Meaning, Criticisms & Real-World Uses

What Is Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a popular momentum indicator used in technical analysis to measure the speed and change of price movements. As one of the most widely recognized oscillators, the RSI helps traders and investors identify overbought and oversold conditions in the market. Its value is plotted on a scale from 0 to 100, providing insights into the strength or weakness of an asset's recent price action. The Relative Strength Index is typically applied to financial instruments like stocks, commodities, and currencies to anticipate potential reversals or confirm existing trends in asset prices.

History and Origin

The Relative Strength Index was developed by J. Welles Wilder Jr., a mechanical engineer turned market analyst. He introduced the RSI in his groundbreaking 1978 book, "New Concepts in Technical Trading Systems".⁵ Wilder's aim was to create a more reliable and less erratic momentum oscillator compared to those available at the time. His systematic approach, influenced by his engineering background, led to the creation of several widely used technical indicators, with the Relative Strength Index becoming one of his most enduring contributions. The indicator was initially designed for the commodities market but quickly found broad application across various financial markets due to its simplicity and effectiveness.⁴

Key Takeaways

The Relative Strength Index (RSI) is a momentum oscillator used in technical analysis.
It quantifies the speed and change of price movements, ranging from 0 to 100.
Traditionally, an RSI reading above 70 indicates overbought conditions, while a reading below 30 signals oversold conditions.
RSI can help identify potential trend reversals, divergence, and convergence between price and momentum.
While a powerful tool, the Relative Strength Index is most effective when combined with other indicators and used within the broader market context.

Formula and Calculation

The Relative Strength Index is calculated using a two-step process, typically over a 14-period lookback (e.g., 14 days for a daily chart).

Step 1: Calculate Average Gain and Average Loss

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

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

For the initial 14-period calculation, a simple average is used.
Current Gain: The positive change in price from the previous close to the current close. If the price closes lower, the gain is 0.
Current Loss: The positive value of the negative change in price from the previous close to the current close. If the price closes higher, the loss is 0.

Step 2: Calculate Relative Strength (RS) and RSI

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

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

This formula normalizes the Relative Strength value into an oscillator that fluctuates between 0 and 100, making it easier to identify extreme readings.

Interpreting the Relative Strength Index (RSI)

The interpretation of the Relative Strength Index revolves around its overbought and oversold levels, typically set at 70 and 30, respectively. When the RSI rises above 70, an asset is generally considered overbought, suggesting that its price may have risen too quickly and could be due for a downward correction or reversal. Conversely, when the RSI falls below 30, the asset is often seen as oversold, indicating that its price may have fallen excessively and could be poised for an upward rebound.³

Beyond these traditional levels, traders also look for divergence between the Relative Strength Index and the price. For instance, if an asset's price makes a new high, but the RSI makes a lower high, this bearish divergence can signal weakening upward momentum and a potential trend reversal. Similarly, a bullish divergence occurs when the price makes a new low, but the RSI makes a higher low, suggesting that selling pressure is diminishing. Traders also analyze the centerline at 50; a move above 50 indicates increasing bullish momentum, while a move below 50 suggests increasing bearish momentum.²

Hypothetical Example

Consider a stock, "DiversiCo Inc.," which has been steadily increasing in price. A trader is using the Relative Strength Index with a 14-day period to identify potential entry or exit points.

Day	Closing Price	Daily Change	Gain	Loss	Avg Gain (14-day)	Avg Loss (14-day)	RS	RSI
...	...	...	...	...	...	...	...	...
14	$105.00	+$2.00	$2.00	$0.00	$1.50	$0.75	2.00	66.67
15	$106.50	+$1.50	$1.50	$0.00	$1.50	$0.70	2.14	68.27
16	$108.00	+$1.50	$1.50	$0.00	$1.50	$0.65	2.31	69.78
17	$109.50	+$1.50	$1.50	$0.00	$1.50	$0.60	2.50	71.43
18	$110.00	+$0.50	$0.50	$0.00	$1.42	$0.56	2.54	71.74
19	$109.00	-$1.00	$0.00	$1.00	$1.32	$0.60	2.20	68.75
20	$107.50	-$1.50	$0.00	$1.50	$1.23	$0.67	1.84	64.88

On Day 17, the RSI for DiversiCo Inc. crosses above 70, reaching 71.43. This signals that the stock is now in overbought territory, indicating that its recent price gains might be unsustainable. The trader, recognizing this potential warning, might consider taking partial profits or tightening their stop-loss to protect against a potential pullback. On Day 19 and 20, the price starts to decline, and the RSI falls, confirming the initial overbought signal and a shift in momentum.

Practical Applications

The Relative Strength Index finds broad practical application across various aspects of financial markets, primarily within the realm of technical analysis. Traders use the RSI to generate trading signals by identifying potential entry and exit points. For instance, an asset that has been significantly declining and whose RSI moves below 30 and then crosses back above it might be seen as a buying opportunity, suggesting that the selling pressure is easing. Conversely, an asset that has rallied sharply, and whose RSI moves above 70 and then drops back below it, could signal a selling opportunity.¹

Beyond simple overbought/oversold signals, RSI is often combined with other analytical tools to enhance decision-making. Traders frequently look for chart patterns on the RSI itself, such as trendlines or double tops/bottoms, which can mirror or precede price patterns. It is also used in conjunction with other momentum indicators, like the Moving Average Convergence Divergence (MACD), or with support and resistance levels on the price chart to confirm potential reversals. Academic research has investigated the effectiveness of RSI in various markets, with some studies suggesting it can outperform a simple buy-and-hold strategy under certain conditions. In practice, the Relative Strength Index is a valuable tool for understanding market sentiment and assessing the underlying strength or weakness of price trends.

Limitations and Criticisms

While a widely used technical indicator, the Relative Strength Index (RSI) has several limitations and criticisms. A primary concern is its tendency to generate "false signals," especially in strongly trending markets. During a strong uptrend, the RSI can remain in overbought territory (above 70) for extended periods without an immediate price reversal, potentially leading traders to exit positions prematurely. Similarly, in a powerful downtrend, the RSI can stay oversold (below 30) for a prolonged time, causing traders to buy too early.

Another criticism is that the standard 70/30 thresholds are not universally effective across all market conditions or asset classes. Some traders adjust these levels based on an asset's typical volatility or the prevailing market regime. Furthermore, while the RSI is a momentum indicator, it can lag behind rapid price movements, meaning signals may appear after a significant portion of the move has already occurred. This characteristic can sometimes lead to missed opportunities or sub-optimal entry/exit points, particularly in fast-moving markets. For some asset classes or specific trading contexts, relying solely on the Relative Strength Index for trading signals may not yield consistent profits, as demonstrated by studies on its application in certain foreign exchange markets. Therefore, applying the Relative Strength Index effectively requires integrating it with other forms of analysis and sound risk management strategies.

Relative Strength Index (RSI) vs. Moving Average Convergence Divergence (MACD)

Both the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD) are popular momentum indicators used in technical analysis, but they measure momentum differently and are often used in complementary ways.

The Relative Strength Index (RSI) is an oscillator that measures the speed and change of price movements, specifically identifying overbought and oversold conditions by comparing the magnitude of recent gains to recent losses. It is bounded between 0 and 100. RSI is particularly useful in range-bound markets, where it can signal potential reversals from extreme levels.

In contrast, the Moving Average Convergence Divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of an asset's price. It consists of the MACD line (difference between two exponential moving averages), a signal line (exponential moving average of the MACD line), and a histogram. MACD is better suited for identifying new trends, trend reversals, and the strength of a trend. It has no upper or lower bounds.

The confusion between the two often arises because both are momentum indicators and are displayed as oscillators below the price chart. However, RSI is primarily about price speed and conditions of overextension, while MACD focuses on the relationship and momentum of moving averages, often generating crossover trading signals. Traders frequently use them together, with RSI identifying potential overbought/oversold turning points and MACD confirming the onset or continuation of a trend.

FAQs

What is a good RSI reading?

A "good" Relative Strength Index reading depends on the market context. Traditionally, an RSI above 70 is considered overbought, and below 30 is oversold. However, in strong uptrends, the RSI can remain above 70 for extended periods, indicating strong bullish momentum rather than an imminent reversal. Similarly, in strong downtrends, it can stay below 30. Some traders consider values between 40 and 60 to indicate a neutral zone, while a break above 50 could suggest bullish momentum, and a break below 50, bearish momentum.

Can RSI be used for all timeframes?

Yes, the Relative Strength Index can be applied to various timeframes, from short-term intraday chart patterns (e.g., 5-minute charts) to longer-term analyses (e.g., weekly or monthly charts). The standard 14-period setting adjusts to the chosen timeframe; for a daily chart, it considers 14 days, while for an hourly chart, it considers 14 hours. Traders often adapt the lookback period (e.g., 7, 9, 21, or 25 periods) and overbought/oversold thresholds (e.g., 80/20 instead of 70/30) to suit the volatility and characteristics of the specific market and timeframe they are analyzing.

Is RSI a leading or lagging indicator?

The Relative Strength Index is generally considered a leading indicator because it attempts to anticipate potential trend reversals by identifying overbought or oversold conditions before a major price change occurs. However, like many technical indicators, it can also exhibit lagging characteristics, particularly when prices are trending strongly and the RSI remains in extreme territory. Its signals are often most reliable when combined with other indicators that provide trend confirmation or volume analysis.

Does RSI work in the stock market?

Yes, the Relative Strength Index is widely used and generally considered effective in the stock market. It helps traders and investors gauge the momentum of individual stocks or broader indices. While it can provide valuable insights into potential buying and selling opportunities, its effectiveness can vary depending on market conditions (e.g., trending vs. range-bound markets) and should ideally be used in conjunction with other forms of analysis, such as fundamental analysis and price action, for more robust decision-making.