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: RSI Indicator Formula

The Relative Strength Index (RSI) formula is:

RSI = 100 - [{100}/{1 + RS}]

In this formula, the RSI = t{Average Gain} /{Average Loss}.

You can calculate the RSI of a stock by averaging price changes over a specific timeframe, typically 14 periods.

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

How Does The Relative Strength Index Work?

Now that you know ‘how to calculate RSI of stock,’ let us look at how RSI works. The RSI works as a momentum oscillator. It measures the speed and change of price movements.

The index is used to compare the magnitude of recent gains to recent losses to determine if an asset is being over-bought or over-sold.

The RSI oscillates between 0 and 100. This oscillation provides a visual representation of the internal strength of a security. This can help the traders identify when a price trend might be reaching an exhaustion point.

What Do RSI Indicator Readings Mean

RSI readings are categorised into specific ranges to identify market conditions.

Here, a reading of more than 70 generally indicates that a stock is "Overbought." It indicates that the stock may be overvalued. It also suggests it might be due for a price correction or a pullback.

Conversely, a reading below 30 indicates "Oversold" conditions. Such a reading suggests the stock may be undervalued and poised for a potential bounce or trend reversal.

What Is RSI Divergence

RSI Divergence can occur when the direction of the price trend and the direction of the RSI indicator move in opposite ways.

Here is an example to understand the RSI better.

Say a stock price makes a "higher high" while the RSI makes a "lower high." It is a bearish divergence. Such a mismatch is a major metric suggesting that the current price momentum is weakening and a trend reversal may be imminent.

What Is RSI Convergence

Along with learning ‘how to calculate RSI,’ it is also important to understand RSI convergence.

RSI Convergence happens when the price of a security and the RSI indicator both move in the same direction, confirming the strength of the current trend.

If the price and the RSI both hit new highs, it indicates strong upward momentum.

This alignment between the security price and the RSI can provide traders with confidence that the existing trend is healthy and likely to continue in the short term.

Limitations Of RSI

The RSI is a powerful solution. However, it is not a standalone solution because it can remain in overbought or oversold territory for long periods during strong trends.

The relative strength index often generates "false signals" in sideways or volatile markets, leading to premature entries or exits.

Additionally, the RSI does not account for major news or sudden market shocks. This means it should always be used alongside other technical indicators for confirmation.

Conclusion

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

Livemint
Charles Schwab