RSI was developed by J. Welles Wilder and published in his 1978 book, "New Concepts in Technical Trading Systems". Today it is one of the most widely used indicators for finding short-term trends in the market that may be interpreted as potential buying and selling opportunities. Although RSI is typically used for trading stocks, investors have also found it to be useful when trading forex (i.e., currency) and options.
How is RSI Calculated?
The RSI indicator uses both current and historical prices within a given time period (typically 14 days) and produces a metric between 0 and 100. It can be calculated using the following equation:
RSI = 100 – [ 100 / ( 1 + RS ) ]
Where:
- RS = Average Gain / Average Loss
To find the RS for a given data set, the first data point must be calculated in the following way to find the average gain and average loss:
- First Average Gain = Sum of Gains over the past 14 periods / 14
- First Average Loss = Sum of Losses over the past 14 periods / 14
Subsequent data points are then calculated as follows:
- Average Gain = [(previous Average Gain) x 13 + current Gain] / 14
- Average Loss = [(previous Average Loss) x 13 + current Loss] / 14
This methodology is a smoothing technique that's similar to the calculation for the exponential moving average (another popular technical indicator used to find buy and sell signals).
Note that RSI can be modified for other time periods. For example, some investors choose to look at the 10-day RSI instead of the standard 14 days. Modern trading software makes it possible to change the time period with the click of a button.
How Does the RSI Indicator Work?
The data points of RSI indicator are typically plotted along a horizontal time axis and compared to the security’s price chart for the same time period. Reviewing these two charts in conjunction with one another can help reveal details about their momentum.
Trend Reversals
The most widely used way to use the RSI indicator is to look for instances where a corrective trend reversal or price pullback is about to occur. This is done by looking for instances where the security may be either overbought or oversold.
- Overbought - Occurs when the RSI goes above the 70-line and then crosses back below it. This signals that the security’s price is increasing rapidly within a short period of time and may reverse lower signaling a good exit or selling opportunity.
- Oversold - Occurs when the RSI goes below the 30-line and then crosses back above it. This signals that the security’s price is decreasing rapidly within a short period of time and may reverse higher signaling a good entrance or buying opportunity.
Oftentimes, the price of a security and its RSI indicator move in opposite directions. For example, the stock price goes up while the RSI goes down.
When this happens, it's referred to as divergence and might display a change in momentum before there’s a corresponding change in price. Divergences can be viewed in one of two ways:
- Bullish divergence - This occurs when the stock makes lower lows while the RSI makes higher lows. This can indicate downward momentum is slowing and a bullish reversal may be upcoming.
- Bearish divergence - This occurs when the stock makes higher highs while the RSI makes lower highs. This can indicate upward momentum is slowing and a bearish reversal may be upcoming.
RSI vs. MACD
Some investors may confuse RSI with MACD. While both indicators are used to look for potential bullish and bearish opportunities, the way they work is very different.
MACD stands for "moving average convergence divergence" and has an oscillating plot similar to RSI that investors used to compare against the price of a security. However, MACD is looking for trading signals by measuring the divergence of two exponential moving averages: the 12-day period versus the 26-day period. By contrast, the RSI is only using the security's price momentum to find entrance and exit points.
Drawbacks of Using RSI
As with many market analysis indicators, RSI is what’s called a lagging indicator. This means it relies on historical data and is not forward-looking. Therefore, it can't factor in recent earnings projections or economic news which can greatly affect the company's share price.
Additionally, the signals of the RSI are not always accurate. Because securities can be overbought or oversold for long periods of time, the RSI might suggest a divergence. However, this is not a guarantee of a good buying or selling opportunity.
Investors need to be careful not to rely solely on RSI. It should be used as a confirmation tool rather than a prediction of where a security’s price will go next.
The Bottom Line
The Relative Strength Index is a momentum oscillator that can be used by investors to find signals of when a security is oversold or overbought. It's typically calculated using the relative price changes over a 14-day period. An RSI crossing the 70-line can indicate a potential exit opportunity while crossing the 30-line can indicate a potential buying opportunity.
While RSI can be helpful, it's not perfect and can lead to false signals. Therefore, it should only be used in conjunction with other stock analysis metrics.