Relative Strength Index, with its widely known short name RSI, is an oscillator indicator for technical analysis. It is a technical indicator used in trading to measure the strength of a security’s price action. Traders use technical and fundamental analysis methods extensively for Relative Strength Indicators. Being one of the most preferred and used indicators in the financial markets, RSI is calculated based on the average gain and loss of a security over a specified timeframe, typically 14 days. It simply generates overbought-oversold signals, values ranging from 0 to 100; with readings above 70 indicating overbought conditions and readings below 30 indicating oversold conditions. Adopted widely in finance markets, the relative strength index RSI is a very beneficial and thriving transformation.
To use RSI effectively, traders typically follow these steps:
Identify the security: The first step is to identify the security you want to trade and the timeframe you want to analyze.
Calculate the RSI: Next, you need to calculate the RSI for the time period you select. This can be done using a trading platform or manually, applying the RSI formula.
Interpret the RSI: Once you have calculated the RSI, you need to interpret the readings. Readings above 70 suggest that the security is overbought and may be due for a price correction. Readings below 30 suggest that the security is oversold and may be due for a price rebound.
Use other indicators: To increase the effectiveness of the RSI, traders often use other technical indicators in conjunction with the RSI. For example, in some cases to confirm the signals provided by RSI, traders use moving averages or trend lines.
Develop a trading strategy: Based on the RSI readings and other indicators, traders can develop a trading strategy. For example, a trader may sell a security when the RSI is above 70 and buy a security when the RSI is below 30.
What is Relative Strength Index?
The relative Strength Index (RSI) is a technical indicator used in financial markets to measure the strength and momentum of a security’s price. It was developed by J. Welles Wilder and introduced in his book “New Concepts in Technical Trading Systems” in 1978.
The RSI compares the magnitude of a security’s recent gains to its recent losses and converts this information into a numerical value that ranges between 0 and 100. RSI is obtained by calculating the average gain and average loss over a specific time period, which is usually 14 days, and then dividing the average gain by the average loss to reach a relative strength value.
The RSI is often used to identify overbought or oversold conditions in a financial security. Generally, a reading above 70 is considered overbought and may suggest that the security is due for a price correction or reversal, while a reading below 30 is considered oversold and may suggest that the security is undervalued and due for a potential price rebound. Traders and analysts also use RSI as a signal for potential trend changes, divergence, and confirmation of price trends.
How is Relative Strength Index calculated?
RSI was developed by J. Welles Wilder, who is mostly known for his works in technical analysis. RSI calculates the current strength of the price, relative to the calculation period. The relative strength index formula can easily be applied at basic Excel spreadsheets.
The RSI is calculated using the following steps and formula:
- Calculate the average gain or loss:
To calculate the RSI, the average gain or loss of a security over a specified time period is calculated. This is typically done using a 14-day range. Average gain means the average of all upward bars in the calculation period whereas average loss is the average of all downward bars.
- Calculate the relative strength:
The relative strength is calculated by dividing the average gain by the average loss. This provides a value between 0 and 100, where a higher value indicates that the security is gaining strength.
RS = Average Gain / Average Loss
- Calculate the RSI:
The RSI is then calculated using the Relative Strength Value. RS now turns into an Index to fit in all charts.
The formula for the RSI is: RSI = 100 – (100 / (1 + RS))
How Does the Relative Strength Index Work?
The Relative Strength Index (RSI) is a momentum indicator that measures the speed and change of price movements in financial markets. It compares the magnitude of recent gains to recent losses to determine if a security is overbought or oversold in a given period of time.
Known for its “overbought” and “oversold” signals, RSI ranges from value 0 to 100. When the RSI is above 70, the security is considered overbought, and when the RSI is below 30, the security is considered oversold. Traders often use these overbought and oversold levels as potential buy or sell signals.
The RSI is extensively used by traders to identify potential price reversals, confirm trends, and generate trading signals. However, it’s important to note that the RSI is not a perfect indicator and should be used jointly with other technical indicators and fundamental analysis to make trading decisions. Traders should also be aware of the limitations of the RSI, including its sensitivity to market volatility and its inability to predict future price movements with certainty.
RSI can be beneficial in various ways. Here are some ideas for investors about how to benefit from RSI:
Overbought and Oversold
RSI index shows the recent strength of the price in the 0 to 100 value range. If the upward or downward trending moves come too fast relative to the calculation period which is 14 day by default, it gives you an overbought or oversold signal. These signals, like any indicator in technical analysis, may not be too accurate but are relatively successful among most of the used indicators, especially in ranking charts.
The chart above is showing the Gold price, roughly for one and a half years. Gold is ranging between 1675 and 2080 throughout the chart which provides a good example for RSI’s overbought and oversold use.
30 and 70 are accepted as limits and above 70 is the overbought zone while below 30 is the oversold zone. There are 5 oversold and 3 overbought signals that came during the period. Some of them start a short trend and some of them cause a mild correction. The time to buy and sell can be wary between traders, but perhaps the most correct one is not getting in a trade at the same time as the signal came, but rather waiting for a reversal. This means, that when RSI is past 70 to above, the up move might continue for a while. When its strength starts to weaken, and the RSI falls below 70 might be a good time to sell. Same as the buy signal, after crossing 30 to above, it might be a good time to buy.
Positive and Negative Divergence
The markets do not always move in a flat range, the prices tend to move upwards or downwards. The relative strength index’s overbought and oversold signals might not work very well during that time as it is calculating the strength of the trends rather than the prices. During those times, divergence can be used as a signal to confirm or contradict other technical indicators or chart patterns and can help traders make informed decisions about buying, selling, or holding a particular asset.
Divergence is not a direct buy or sell signal. Positive and negative divergence are concepts in technical analysis that refer to the relationship between the price and a technical indicator, such as the relative strength index (RSI) or moving average convergence divergence (MACD).
Positive Divergence occurs when the price is making lower lows, but the technical indicator is making higher lows. This suggests that the momentum of the downtrend is weakening and that a potential trend reversal or price correction may be imminent. Therefore, during a downtrend, while the price continues to make lower lows, if RSI makes higher lows at the same time, it is called a positive divergence, which signals a “buying opportunity”.
Negative divergence, on the other hand, occurs when the price of an asset is making higher highs, but the technical indicator is making lower highs. This suggests that the momentum of the uptrend is weakening and that a potential trend reversal or price correction may be imminent. Therefore, during an uptrend, while the price continues to make higher highs, if RSI makes lower highs at the same time, it is called a negative divergence, which signals a “selling opportunity”.
In the example, S&P 500’s CFD chart shows both positive and negative divergence.
Trend Confirmation
RSI can be used to confirm the continuation of an existing trend to enter a trade in the direction of the trend. With no clear divergence in sight, a reversal from the overbought zone for downtrends and a reversal from the oversold zone for uptrends can be a good signal for the trend to continue.
What Is a Healthy RSI Number?
The technical analysis indicator, RSI is used to measure the strength of price movements of a security over a given period in the financial markets. Ranging from 0 to 100, it is commonly used to identify whether a security is overbought or oversold.
However, it’s important to note that there is no specific “healthy” RSI number as it depends on individual security, market conditions, and trading strategies. Some traders may prefer to use different RSI levels as thresholds for overbought or oversold conditions based on their experience and analysis.
In general, an RSI reading above 70 is considered overbought, indicating that the security may be due for a price correction or reversal. Conversely, an RSI reading below 30 is considered oversold, indicating that the security may be due for a price rebound or reversal.
Also, there is another way to read the relative strength index, considering when it is over and under the midpoint, 50. While the price is trending, over 50 RSI shows a strong upward trend. An RSI reading below 50 is considered as the trend’s momentum is ending and bears start to be in charge. As long as RSI stays below 50, a downtrend is expected to form, as crossing over 50 might be a sign of trend reversal. When RSI crosses above its moving average, that means a buy signal. When RSI crosses under its moving average, it means a sell signal. Ranging with sharp reversal or trending markets give relatively good results while trends with low slopes and tight-ranging markets often give lots of false signals.
As the 50 value does not always act as supportive, this is a rare use of RSI. But when formed like the Apple example above, it gives very good trade entry and exit points.
Moving Average Cross (MAC)
Crossing 50 does not always give healthy signals as these signals may be very late. An alternative way is using a moving average. Moving Average Cross (MAC) involves the use of two or more moving averages with different time periods and comparing their crossover points. Moving Average Cross (MAC) is a popular technical analysis strategy used in trading to identify potential changes in a security’s price trend.
The basic idea behind MAC is to use a short-term moving average, such as the 20-day moving average, and a long-term moving average, such as the 50-day moving average, and compare their crossover points. When the short-term moving average crosses above the long-term moving average, it is considered a bullish signal, indicating that the security’s price is likely to trend upwards. Conversely, when the short-term moving average crosses below the long-term moving average, it is considered a bearish signal, indicating that the security’s price is likely to trend downwards.
Traders usually use Moving Average Cross in conjunction with other technical indicators and chart patterns to confirm their trading decisions. It is important to note that traders should always conduct thorough research and risk management before making any trading decisions.
Weak Points of the RSI
Like all of the indicators, the relative strength index also has many weaknesses. We discussed each of these weak points briefly in the “how to use the RSI indicator” section. But seeing a concrete example might be better for understanding.
In the example above, USDJPY is trending aggressively. Because of the FED’s tightening steps while BOJ (Bank of Japan) keeps its extra loose monetary policy, the uptrend has a lot of fuel to keep going north. Because of the extreme fundamental pressure, RSI’s overbought signals became obsolete.
If you read the divergence section, you know divergence gives better results for trendy markets. But despite RSI’s downtrend and massive negative divergence, USDJPY continues to push up. Perhaps an over 50 approach can be used, but it also gives lots of fake signals.
Different uses of RSI give different results in many securities and many different markets. But when there is a big fundamental gap to be filled in, most of the indicators give lots of false positive signals and it is better to stay careful about these extreme situations.
A Basic Backtest Example for RSI
Indicators has a lot of different using styles. It is wise to choose the best one for the situation or create your way. In this example below, we test the most basic use of RSI, below 30 and above 70 reversals. It is calculated for EURUSD and XAUUSD for the last 5 years.
Buy and Hold: When RSI crosses 30 to above, the system will buy and hold until a sell signal comes.
Sell and Hold: When RSI crosses 70 to below, the system will sell and hold until a buy signal comes.
XAUUSD
Gold had one major uptrend in the last five years. All of the other times it has ranged in two wide and flat zones. The backtest gave 6 long and 6 short signals with a total of 36.26% profit and a 31.11% maximum drawdown. The big drawdown came with the trending period and most of the profit came from the ranging period as expected. Only 3 of the 12 trades end up in a loss.
EURUSD
EURUSD has an extremely tight, low slope trend and another 2 major, high slope trends. Because of having almost no flat period, only 4 signals came and only one of them was profitable. The total loss is 27.66% and the maximum drawdown is 28.03.
RSI is a widely adaptable indicator that can give successful signals to almost any financial market, depending on its prompt and accurate usage. Like other indicators used in technical analysis, RSI may involve some weaknesses. However, when combined with other indicators and chart patterns, RSI can be a powerful tool for any trader, both new and experienced.
