The Relative Strength Index (RSI) is one of the most popular technical indicators. It is a momentum indicator that helps identify the turning points. It was developed by J.W Wilder who created other indicators like the Average True Range (ATR), ADX, and Parabolic SAR.
Other types of momentum indicators are MACD-Histogram, Rate of Change, Stochastic, and Force Index. They help traders identify periods when the assets are either overbought or oversold.
The RSI is able to determine turning points by monitoring the changes in the closing prices. For ordinary traders, while understanding the origin and mathematical foundation of any technical indicator is okay, it is not mandatory. This is because these indicators are provided for free in trading platforms like MT4 and easyMarkets Trading Platform.
The formula for calculating the RSI for any asset is:
RSI = 100 – 100/ 1+ RS
Where RS = Smoothed Average Gain / Smoothed Average Loss
Average Gain = Sum of Gains in the last X days
Average Loss = Sum of Losses in the last X days.
In most cases – and in default in most trading platforms – the value of X is usually 14. To make the indicator more sensitive to the asset you are trading, you can narrow down the X figure.
The RSI oscillates between 0 and 100 values. To use the indicator for analysis, traders typically add it to the daily charts and watch for the values. The most accepted / common way of interpreting the RSI is to look at the 30 and 70 values. However, in bull markets, some traders use the 40 and 80 level while in bear markets they use the 20 and 80 levels.
When the value of the RSI falls to 30 and below, it is said that the asset is oversold which tells the trader to initiate a long position. A further fall below 30 is a further indication that the asset is oversold. This is illustrated better in the chart below.
On the other hand, when the RSI value goes above 70, it is considered overbought. An RSI figure further above 70 and closer to 100 presents traders with a sell signal. This is illustrated in the chart below.
Apart from finding the oversold and overbought positions, traders use the RSI to find the divergence. A bearish divergence happens when the price of an asset is rising while the RSI is falling. This is an indication that the price could correct lower because of the slowing buying momentum.
On the other hand, a bullish divergence happens when the price of an asset is going down while the RSI is moving up. This is usually an indication that the price could move up because of the slowing momentum.
When using the RSI to measure divergence, traders needs to be careful because the period before the divergence is confirmed can take time.
Like all indicators, RSI is better used together with other indicators. An ideal method is to test the momentum of an asset with other momentum indicators like Stochastic. If the two indicators confirm that the price of the asset is overbought, oversold, or is diverging, you can confirm this using trend following indicators like the Moving Averages and the Average Directional Index.
As a trader, you need to understand that the RSI – even when combined with other indicators – will not always work out. In several occasions, assets can stay in the overbought or oversold territory for a very long period. For example, consider the General Electric chart shown above.