The Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a financial technical analysis oscillator showing price strength by comparing upward and downward close-to-close movements. It was developed by J. Welles Wilder and published in Commodities magazine (now called Futures magazine) in June 1978, and in his New Concepts in Technical Trading Systems the same year.

Calculation

The standard calculation for RSI uses 14 trading days as the basis, which can be adjusted to meet the needs of the user. The well-known formula for RSI is as follows:

RSI = 100 – 100 / (1 + RS)

RS = Average Gain / Average Loss

Average Gain = [(previous Average Gain) x 13 + current Gain] / 14
First Average Gain = Total of Gains during past 14 periods / 14

Average Loss = [(previous Average Loss) x 13 + current Loss] / 14
First Average Loss = Total of Losses during past 14 periods / 14

Note: “Losses” are reported as positive values.

How To Use
Overbought/Oversold

RSI helps to signal overbought and oversold conditions in a security. The indicator is plotted in a range between zero and 100. A reading above 70 is used to suggest that a security is overbought, while a reading below 30 is used to suggest that it is oversold. This indicator helps traders to identify whether a security’s price has been unreasonably pushed to current levels and whether a reversal may be on the way. Generally, if the RSI rises above 30 it is considered bullish for the underlying stock. Conversely, if the RSI falls below 70, it is a bearish signal.

Go long when RSI falls below the 30 level and rises back above it

Go short when RSI rises above the 70 level and falls back below it

Divergences

Buy and sell signals can also be generated by looking for positive and negative divergences between the RSI and the underlying stock. For example, consider a falling stock whose RSI rises from a low point back up to a high point. Because of how the RSI is calculated, the underlying stock will often reverse its direction soon after such a divergence. As in that example, divergences that occur after an overbought or oversold reading usually provide more reliable signals.

Go long on a positive divergence where the first trough is below 30.
Go short on a negative divergence where the first peak is above 70.

Centerline Crossover

The centerline for RSI is 50. Readings above and below can give the indicator a bullish or bearish tilt. On the whole, a reading above 50 indicates that average gains are higher than average losses and a reading below 50 indicates that losses are winning the battle. Some traders look for a move above 50 to confirm bullish signals or a move below 50 to confirm bearish signals.

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