Technical indicator

Relative Strength Index (RSI): Definition, Formula, Example, and FAQs

What Is Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a prominent momentum indicator used in technical analysis. It functions as an oscillator that measures the speed and change of price movements, providing insights into whether an asset is overbought or oversold. The RSI is typically displayed on a scale from 0 to 100, plotted below the price chart of a security. Traders often use the Relative Strength Index to identify potential trend reversals, confirm existing market trend strength, and generate trading signals.

History and Origin

The Relative Strength Index was developed by J. Welles Wilder Jr., a mechanical engineer turned real estate developer and technical analyst. Wilder introduced the RSI, along with several other foundational technical indicators, in his seminal 1978 book, "New Concepts in Technical Trading Systems."¹⁸, ¹⁹ This influential work outlined various mathematical systems for trading commodities and futures, and the RSI quickly became one of the most widely adopted tools in financial markets. At the time of its creation, traders often calculated indicators manually, making Wilder's systematic approach revolutionary for its clarity and applicability to different asset classes.¹⁷ The concepts from "New Concepts in Technical Trading Systems" continue to be studied by technical analysts today.¹⁵, ¹⁶

Key Takeaways

• The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements.
• RSI values typically range from 0 to 100, with readings above 70 indicating overbought conditions and below 30 indicating oversold conditions.
• It is used to identify potential trend reversals, confirm trend strength, and spot divergences between price and momentum.
• While useful, the RSI is often more effective when combined with other technical indicators and considered within the broader market context.
• The standard calculation period for RSI is 14 periods, though this can be adjusted.

Formula and Calculation

The Relative Strength Index is calculated in two main steps. First, the "Relative Strength" (RS) is determined, which is the ratio of the average gain to the average loss over a specified number of periods. Second, the RS value is smoothed and transformed into an oscillator between 0 and 100.

The standard period length for the RSI calculation is 14.

1. Calculate Average Gain (AG) and Average Loss (AL):
   For the initial calculation (typically the first 14 periods):

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

   (Note: Losses are expressed as positive values in this calculation.)

   For subsequent periods, a smoothing component is introduced:

   $$\text{Average Gain}_\text{current} = \frac{(\text{Average Gain}_\text{previous} \times 13) + \text{Current Gain}}{14}$$ $$\text{Average Loss}_\text{current} = \frac{(\text{Average Loss}_\text{previous} \times 13) + \text{Current Loss}}{14}$$

2. Calculate Relative Strength (RS):

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

3. Calculate Relative Strength Index (RSI):

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

This formula ensures that the RSI value remains bounded between 0 and 100, making it an effective oscillator for assessing price momentum.

Interpreting the Relative Strength Index (RSI)

The Relative Strength Index provides clear visual cues for market conditions. The traditional interpretation involves specific levels:

• Overbought Conditions: When the RSI rises above 70, it is generally considered that the asset is overbought, suggesting that the price has risen too quickly and may be due for a pullback or reversal.
• Oversold Conditions: Conversely, an RSI reading below 30 typically indicates that the asset is oversold, implying that the price has fallen too far and might be poised for a rebound.

Beyond these fixed levels, traders also look for:

• Divergence: This occurs when the price of an asset moves in one direction while the RSI moves in the opposite direction. For instance, if a stock makes a new high but its RSI makes a lower high, it could signal weakening bullish momentum indicator and a potential reversal.¹⁴
• Failure Swings: These are patterns within the RSI itself that do not correspond with new price highs or lows, often signaling a change in momentum ahead of price action.¹³
• Centerline Crossover: The 50-level on the RSI often acts as a centerline. A move above 50 generally indicates positive momentum, while a move below suggests negative momentum.¹² This can help confirm the prevailing market trend.

It's important to note that while these levels and patterns offer valuable trading signals, they should be interpreted in conjunction with other technical analysis tools and not in isolation.

Hypothetical Example

Consider a hypothetical stock, "GrowthTech Inc." (GTI), which has been trending upwards. A trader is using the Relative Strength Index (RSI) with a 14-period setting to monitor its momentum.

1. Initial Uptrend: GTI's price rises steadily, and its RSI hovers between 50 and 70, indicating strong but healthy upward momentum.
2. Overbought Signal: After a rapid price surge, the RSI for GTI pushes above 70, reaching 78. This signals to the trader that GTI may be entering overbought territory, suggesting a short-term price correction or consolidation could be imminent.
3. Bearish Divergence: Days later, GTI's stock price makes a new high, but the RSI fails to reach its previous high, instead peaking at 72. This is a bearish divergence, indicating that the upward price movement is not supported by strong underlying momentum indicator. The trader interprets this as a warning sign that the uptrend might be losing steam.
4. Confirmation and Pullback: Following the divergence, GTI's price starts to decline. The RSI crosses back below 70 and then drops below the 50-level, further confirming the shift in momentum from bullish to bearish. The trader might consider taking profits or adjusting their risk management strategy based on these signals.

This example illustrates how the RSI, by itself and in conjunction with price action, can provide actionable insights for traders observing short-term market dynamics.

Practical Applications

The Relative Strength Index is a versatile tool widely applied across various aspects of investing and market analysis:

• Entry and Exit Points: Traders often use RSI to identify potential entry points when an asset is oversold (RSI below 30) and potential exit points when it is overbought (RSI above 70). This is particularly effective in range-bound markets where prices oscillate between support and resistance levels.
• Trend Confirmation: During a strong uptrend, the RSI tends to stay above 50, often bouncing off the 40-50 range. In a downtrend, it typically remains below 50, facing resistance around the 50-60 range. This can help confirm the strength and direction of a market trend.¹¹
• Divergence Trading: Identifying divergences between price and RSI is a common application. Bullish divergence (price makes lower low, RSI makes higher low) can signal a potential upward reversal, while bearish divergence (price makes higher high, RSI makes lower high) can signal a potential downward reversal. This can be a powerful trading signal for anticipating shifts in price action.¹⁰
• Integration with Other Indicators: The RSI is rarely used in isolation. It is frequently combined with other technical indicators like moving averages, candlestick charts, and chart patterns to enhance the reliability of signals. For example, a buy signal from an oversold RSI might be confirmed by a bullish engulfing pattern on a candlestick chart or a breakout above a key moving average.⁹

Limitations and Criticisms

While the Relative Strength Index is a popular and valuable technical indicator, it is not without its limitations:

• False Signals in Strong Trends: One of the primary criticisms is that the RSI can generate misleading signals in strongly trending markets. During a powerful uptrend, the RSI may remain in overbought territory (above 70) for extended periods, even as the price continues to rise. Conversely, in a strong downtrend, it can stay in oversold territory (below 30). Acting solely on these signals could lead to premature exits or entries against the prevailing trend.⁸
• Lagging Nature: Like many momentum indicators, the RSI is derived from past price data, meaning it can sometimes lag behind rapid shifts in price action. This can lead to delayed trading signals in fast-moving, volatile markets.⁶, ⁷
• Subjectivity in Interpretation: While the 70/30 levels are standard, some traders adjust these thresholds (e.g., 80/20) for different assets or market conditions, which introduces an element of subjectivity. Moreover, interpreting divergences and failure swings requires a degree of experience and can be prone to misinterpretation by novice users.
• Standalone Usage Not Recommended: Academic research and practical experience suggest that the RSI is highly unreliable when used as a standalone tool for trading decisions.⁵ Its effectiveness significantly improves when it is combined with other technical analysis methods, such as trend lines, support and resistance levels, or volume analysis.⁴
• Lack of Price Target: The RSI indicates momentum and potential reversals but does not provide a specific price target for a subsequent move. Traders need to rely on other tools or analysis for profit targets.

Despite these limitations, understanding the nuances and combining the RSI with a comprehensive trading strategy that includes sound risk management can enhance its utility.

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

The Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD) are both popular momentum indicators, but they measure different aspects of price movement and are interpreted differently. The primary distinction lies in what they track:

While the RSI focuses on the magnitude of recent gains versus losses to identify extreme price conditions, the MACD tracks the relationship between different moving averages to show changes in a trend's strength and direction.³ Due to their complementary nature, many traders use both indicators together to confirm signals and gain a more comprehensive view of market dynamics. For instance, an RSI oversold signal might be considered more reliable if the MACD also shows a bullish crossover.

FAQs

What does a high RSI reading indicate?

A high Relative Strength Index reading, typically above 70, indicates that an asset is considered overbought. This suggests that the price has risen significantly in a short period and may be due for a pause, pullback, or reversal.

What does a low RSI reading indicate?

A low Relative Strength Index reading, typically below 30, indicates that an asset is considered oversold. This suggests that the price has fallen sharply and may be poised for a bounce or reversal to the upside.

Can RSI predict future price movements?

The Relative Strength Index is a technical indicator based on past price data. It helps analyze the current momentum and potential turning points but does not predict future price movements with certainty. It provides probabilities and insights into market sentiment. Like all indicators, it's best used as part of a broader analysis, including price action and other confirming tools, to inform trading decisions.

What is RSI divergence?

RSI divergence occurs when the price of an asset moves in one direction while the Relative Strength Index moves in the opposite direction. For example, if a stock's price makes a new high but its RSI fails to make a new high, this "bearish divergence" can signal weakening upward momentum indicator and a potential reversal. Conversely, a "bullish divergence" (price makes a lower low, RSI makes a higher low) can indicate a potential upward reversal.²

Is a 14-period RSI always the best setting?

The 14-period setting is the most common and widely used for the Relative Strength Index. However, traders can adjust this period based on their trading style and the specific asset or timeframe being analyzed. A shorter period (e.g., 7 or 9) makes the RSI more sensitive and generates more signals, while a longer period (e.g., 21 or 28) makes it smoother and generates fewer, but potentially more reliable, signals. The "best" setting often depends on the volatility and characteristics of the market being traded.¹