What is the Relative Strength Index and Why Should Every Investor Know about It?

Trend analysis and price forecasting are central to investment decision-making within financial markets. Technical analysts rely on a range of indicators to assess market conditions and predict potential price movements. Among these tools, momentum indicators help measure the speed and strength of price changes. The Relative Strength Index (RSI) is one such indicator, used to identify overbought or oversold conditions in a security.

This blog explains the RSI, how it is calculated, and how investors use it to inform their trading strategies.

What is the Relative Strength Index?

Relative Strength Index or RSI index is a technical indicator used to understand the momentum of a price trend of a stock, index, or any other tradable asset. It helps signal when to buy and sell in a trending market. The index oscillates between 0 and 100. A lower RSI value (closer to 0) indicates an oversold position, while a higher value (closer to 100) means an overbought condition.

Who developed RSI?

The RSI indicator formula was first introduced in the book ‘New Concepts in Technical Trading Systems’, authored by J. Welles Wilder Jr. He also discussed it in ‘Commodities’ magazine in June 1978. Wilder was a well-known technical analyst, real estate developer, and mechanical engineer.

Core concept of RSI

The core concept behind RSI is measuring the Relative Strength (RS) of a price change or a trend. RSI tracks the speed and magnitude of recent price changes in a stock, commodity, or any other tradable asset. It compares the simple moving average (SMA) of gains to the SMA of losses over a specific period.

A gain (G) indicates the market moved up, while a loss (L) means it declined. While analysts can choose any time period to calculate RSI, a 14-period (days, weeks, or months) is the most commonly used setting, depending on the investment horizon.

How to calculate: RSI indicator formula

We now have a broader understanding of what is RSI in the share market or other trading exchanges. Modern trading analysis software can automatically calculate and plot moving RSI values for any chosen period by an investor. However, it is important to know how to calculate the relative strength index values for a better understanding of how this tool signals an oversold or overbought market.

We shall understand the RSI formula in the following steps. Our reference for RSI calculation will be a period of 14 days.

1. Average gains and losses

Average gain for a 14-day period will be the sum of daily gains divided by the number of days during which daily closing prices were higher than the preceding day’s closing price.

• Daily gain = Current close - Previous close
• Average gain = (Sum of daily gains/number of days market gained)

Average loss for the same period is the sum of daily losses divided by the number of days with daily closing prices less than the preceding day’s closing price.

• Daily loss = Previous close - Current close
• Average loss = (Sum of daily losses/number of days market lost)

2. Calculation of relative strength (RS)

The relative strength or RS for the specific period = (Average gain / Average loss)

3. Formula to calculate the Relative Strength Index

Once we have the RS value for the period of our concern, the formula for RSI = 100 - {100/(1+RS)}

Calculation of RSI with an Example

We are calculating a 14-day RSI for a stock price.

• Average gain (market was up 7 days) = Sum of daily gains/number of days = 140/7 = 20
• Average loss (market was down 7 days) = Sum of daily losses/number of days = 70/7 = 10
• Relative strength = 20/10 = 2
• Relative Strength Index = 100 - {100/(1+RS)} = 100 - {100/(1+2)} = 100 - 33.3 = 66.7

Why is RSI important for every investor?

RSI is a crucial momentum indicator with several benefits:

• Magnitude and speed of price change
  The RSI value oscillates between 0 and 100. In an upward-trending market, investors should be cautious about the trend’s strength if the RSI value drops below 50. Similarly, in a downward-trending market, an RSI above 50 may signal a weakening of the downtrend. In markets without a strong upward or downward trend bias, the RSI can typically fluctuate between 40 and 80, depending on the chosen time period.

• Oversold or overbought
  

RSI is an indispensable tool for technical analysts to identify overbought and oversold conditions in any market. An RSI value consistently hovering above 70 in an upward-trending market may indicate the market is overbought and due for a correction. On the other hand, an RSI value in a down market staying consistently below 30 may indicate oversold and due for a rebound. An overbought market is ideally a good time to sell off, and an oversold market is suitable for purchases.

• Identifying the divergences
  

In technical analysis, a divergence is an indicator of potential trend changes. The ability to identify divergences can therefore be key to making profitable trading and investment decisions. Tracking and comparing the Relative Strength Index and price movements can provide valuable signals for spotting divergences. For example, if stock prices are making lower lows while the RSI has bottomed out or is beginning to rise. This may signal that selling pressure is losing steam and the market is at a point of divergence.

• Final takeaway
  

The Relative Strength Index is an effective technical analysis tool for analysing market price trends of any asset class. However, investors avoid relying solely on RSI or any other single indicator. Successful investing involves a balanced approach that includes technical analysis, fundamental research, and an understanding of market sentiment.

Sources

Fidelity
Investopedia
Macroption
Pepperstone
Charles Schwab