Relative Strength Indicator (RSI) – Technical Indicator
Developed by J. Welles Wilder and introduced in his book published in the year 1978 “New Concepts in Technical Trading Systems” the Relative Strength Index (RSI) is a very useful and popular momentum oscillator. The RSI basically compares the magnitude of a security’s recent gains to the magnitude of its recent losses and translates that information into a number that falls on a scale from 0 to 100. Wilder recommends to use 14 periods in his book. But some of the analysts use periods ranging from 10 to 24.
How to calculate the RSI
RSI = (100-(100/(1+RS))
First RS=(Average Gain/Average Loss)
Smoothed RS=(((previous Average Gain X 13 + Current Gain)/14)/(previous Average Loss X 13 + Current Loss)/14))
Average Gain=(Total Gains/n),
Average Loss=(Total Losses/n),
n=number of RSI periods
For a 14-period RSI, the Average Gain equals the sum total all gains divided by 14. Even if there are only 5 gains (losses), the total of those 5 gains (losses) is divided by the total number of RSI periods in the calculation (14 in our above case). The Average Loss is computed in the same way.
Calculation of the First RS value is simple and straight : divide the Average Gain by the Average Loss. All subsequent RS calculations use the previous period’s Average Gain and Average Loss for the purpose of smoothing.
How to interpret and use the results of RSI
Oversold / Overbought
The author Wilder recommended using 70 and 30 as overbought and oversold levels respectively. Generally, if the RSI rises above 30 it is considered bullish for the underlying security. Similarly, if the RSI falls below 70, it is a bearish signal. Some analysts identify the long-term trend and then use the extreme readings for entry points. If the long-term trend is bullish, then oversold readings would be recommended as entry points in the stock.
Divergences
Buy and sell signals can also be generated by having a look at the positive and negative divergences between the RSI and the underlying security. For example, consider a stock which is falling and whose RSI rises from a low point of (for example) 20 back up to say, 60. Because of how the RSI is constructed, the underlying security will many times reverse its direction soon after such a divergence has occurred. As in this example, divergences that occur after an overbought or oversold reading usually provide more reliable signals for a technical analyst.
Centerline Crossover
The centerline for RSI is considered as 50. Readings below and above can give the indicator a bearish or bullish signal. On the whole, a reading above 50 indicates that average gains are higher than average losses and a reading below 50 indicates that losses are more compared to the gains. Some analysts watch a move of the security’s RSI above 50 to confirm bullish signals or a move below 50 to confirm bearish signals.
On the whole RSI is a very useful and reliable tool to identify share reversal points for a stock and works more effectively in a volatile security. As such it should be used alongwith other technical indicators so as to be more accurate while predicting the movements of a security.