Definition: what is the Relative Strength Index (RSI)?
By definition, the Relative Strength Index (RSI) is a technical indicator that measures the strength and speed of price movements of an asset. It belongs to the oscillator category, meaning it operates within a fixed range—in the case of RSI, 0 to 100.
The RSI was developed by J. Welles Wilder to help traders identify overbought and oversold market conditions. It is widely used in stock trading, cryptocurrency trading, and other securities markets to analyse trends and potential trend reversals.
How does the Relative Strength Index (RSI) work?
The Relative Strength Index (RSI) measures the strength of price movements by comparing an asset’s average gains and losses over a given period. The result is displayed on a scale from 0 to 100.
Values above 70 typically indicate overbought conditions, while
Values below 30 suggest an oversold market
The RSI functions as an oscillator, calculating the ratio of positive price movements to negative price movements. This analysis helps traders gauge market sentiment and identify potential turning points in price trends.
Key RSI signals:
Overbought (values above 70): A high RSI may indicate that an asset is overvalued and could be due for a downward correction
Oversold (values below 30): A low RSI often signals that an asset may be undervalued, suggesting a potential upward movement
These signals arise because the RSI measures the strength of current trends, helping traders spot potential reversals. However, the RSI is not always sufficient on its own and is best used alongside other indicators.
RSI Buy and Sell Signals
The RSI index provides traders with insights into potential buying and selling opportunities.
An RSI value rising above 30 often signals a buying opportunity, as the asset was previously oversold
A decline from above 70 to below 70 is commonly seen as a sell signal, indicating overbought conditions
If the RSI moves in the opposite direction to the price, this could suggest a possible trend reversal
Thus, the RSI indicator not only highlights overbought or oversold conditions but also helps traders spot shifts in market strength. Combining RSI with other tools—such as trendlines or additional oscillators—can further enhance its accuracy.
Buy Signals (RSI rises above 30)
If the RSI rises above 30, it suggests that a downtrend may be ending and an uptrend could begin. Traders often see this as a signal to open positions. Using RSI with other indicators can improve entry-point assessments.
Sell Signals (RSI falls below 70)
If the RSI drops from above 70, it is often interpreted as a sign of market cooling. Traders take this as a signal to take profits or close existing positions before a larger correction occurs.
Divergences Between RSI and Price Movements
A divergence occurs when the RSI rises while the asset price falls, or vice versa. Such discrepancies often indicate an upcoming trend reversal. Divergences are crucial as they can serve as early warnings of market changes.
How is the RSI Value calculated?
The RSI value is calculated using the following formula:RSI = 100 – (100 ÷ (1 + RS))
Where RS (Relative Strength) represents the ratio of average price gains to average price losses over a specified period. The standard period is 14 days, but traders can adjust this based on their strategy.
Steps to Calculate RSI:
Determine gains and losses: Calculate the difference between each day’s closing price and the previous day’s closing price
Calculate average gains and losses: Sum up the gains and losses over 14 days
Compute Relative Strength (RS):RS = Average gain ÷ Average loss
Calculate the RSI value:RSI = 100 – (100 ÷ (1 + RS))
Most trading platformsautomatically calculate the RSI index, making the process much simpler. However, understanding the underlying formula and calculation steps helps traders better interpret RSI signals and recognise its potential limitations.
