What is Relative Strength Index (RSI)

How to Calculate Relative Strength Index

The following is the formula to calculate Relative Strength Index:

In this calculation, the average percentage gain or loss is measured over a specific period. The formula treats losses as positive values. During the look-back period, periods with price losses are considered to have a zero average gain, while periods with price increases are treated as having a zero average loss. Generally, the initial RSI value is calculated using 14 periods.

For instance, suppose that in the last 14 days, the market closed higher for seven days, with an average gain of 1%. In the other seven days, it closed lower, with an average loss of -0.8%. The RSI calculation would appear as follows: 

RSI = 100 – [100 / {1 + ((1% /14) /(0.8%/14 )}] = 55.55

How Does the Relative Strength Index Work

The RSI indicator helps you determine whether a security is potentially overpriced or undervalued by analysing recent gains and losses. It is calculated by comparing recent price movements to understand whether the market is trending upward or downward.

This indicator serves two primary purposes: measuring the speed and size of price changes and identifying overbought and oversold conditions.

During strong market moves, RSI often stays in overbought or oversold conditions for extended periods. It also forms chart patterns like double tops and bottoms and trendlines that might not be visible on the price chart itself. Look for support or resistance signs on the RSI. 

In a bull market, the RSI typically ranges from 40 to 90, with the 40-50 range acting as support, and in a bear market, the RSI typically ranges from 10 to 60, with the 50-60 range serving as resistance. These ranges can vary based on the RSI parameters and the strength of the underlying trend for the security or the market.

What do RSI Indicator Readings Mean

The RSI readings often fall within specific ranges during trends. In an uptrend, the RSI usually stays above 30 and sometimes touches 70.

Conversely, in a downtrend, it is uncommon for the RSI to exceed 70. It often drops to 30 or below. These patterns help you assess the trend's strength and potential reversals. 

For instance, if the RSI fails to reach 70 after several upward swings and then falls below 30, the uptrend may weaken and reverse downward. On the other hand, in a downtrend, if the RSI does not reach 30 or fall below it but climbs above 70, the downtrend might weaken and reverse upward. Trendlines and moving averages are useful technical tools to be combined with RSI for better analysis.

What is RSI Divergence

Sometimes, divergence occurs when the RSI does not align with the price movement. Positive divergence occurs when the RSI indicator shows higher lows while the price hits lower lows, indicating a potential reversal from oversold conditions.

Negative divergence happens when the RSI forms lower highs while the price forms higher highs, signalling a potential reversal from overbought conditions. Divergences are common in trending markets but insignificant in sideways or long-term trends.

What is RSI Convergence

RSI convergence usually occurs when prices are falling, especially near the end of a bear market. It suggests a potential trend reversal, indicating that prices might soon rise.

This signal often appears before the actual reversal, making it an early indicator. However, RSI convergence does not always guarantee a reversal, so traders should proceed cautiously.

Important of RSI Indicator

Here are some points highlighting why the RSI indicator is important:

• RSI is a tool that aids traders in capturing market momentum by measuring the fluctuation in prices.
• Traders rely on RSI to spot oversold and overbought markets and determine the right time to enter a trade.
• RSI helps traders identify whether a stock is either overbought or oversold. 
• When a stock becomes overbought, it experiences a rapid surge and may need to correct downward.
• Similarly, when a stock becomes oversold, it experiences a rapid drop and could be ready for a bounce back up.

Limitations of RSI

Although RSI is helpful, it does have a few limitations. These are as follows:

• RSI tells you about past price changes, not future ones, which might cause you to miss trading opportunities. 
• RSI indicator becomes less useful when markets display strong trends.
• Market trends can influence RSI readings, causing the market to remain in overbought or oversold zones for long periods and potentially misleading traders. 

The Bottomline

Using the RSI indicator allows you to make informed decisions about when to enter or exit the financial markets profitably. By understanding its functions and limitations and how to interpret its readings, you can enhance your trading strategy.

Remember to combine RSI with other technical tools to get a comprehensive view of the market, which will help you understand trends and identify potential reversals effectively.