What Is the Relative Strength Index (RSI)?
The Relative Strength Index (RSI) is a technical indicator originally developed by J. Wells Wilder Jr. in his 1978 book "New Concepts of Technical Trading Systems", to measure the degree of price fluctuations and assess whether an asset is overbought or oversold. It is displayed as an oscillator (a line graph that moves between two extrema) on a scale from 0-100.
Traditional interpretation the RSI is that values of 70 or above indicate that an asset is becoming overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates that an asset is undervalued.
What Does the Relative Strength Index (RSI) Measure?
The basic idea behind the RSI is to measure how quickly traders are bidding the price of the asset up or down. Traders will often place this RSI chart below the price chart for the security, so they can compare its recent momentum against its market price.
What Is an RSI Buy Signal?
Some traders consider it a "buy signal" when the RSI of the security falls below 30 (indicating the security is undervalued). However, this signal is not always reliable. For example, the RSI could be under 30 at the beginning of a security’s plunge into a significant downtrend. The security would then continue to trade at oversold levels for an extended period of time.
How is the RSI Calculated?
The RSI is computed with a two-part calculation that starts with the following formula:
The average gain or loss used in the calculation is the average percentage gain or loss during a look-back period. The formula uses a positive value for the average loss. Periods with price losses are counted as 0 in the calculations of average gain, and periods when the price increases are counted as 0 for the calculation of average losses.
The standard is to use 14 periods to calculate the initial RSI value.
Once there are 14 periods of data available, the second part of the RSI formula can be calculated. The second step of the calculation smooths the results.
Limitations of the RSI
The RSI compares bullish and bearish price momentum and displays the results in an oscillator that can be placed below the price chart. Like most technical indicators, the signal is most reliable when in line with long-term trends. True reverse signals are rare and can be difficult to distinguish from false positives. For example, a bullish crossover followed by a sudden drop in stock prices would result in a false positive following the RSI theory strictly. A situations where there is a bearish crossover, but stock prices suddenly rise would result in a false negative following RSI theory strictly. Because RSI is an indicator of momentum, an asset having a lot of momentum in either direction will mean it may remain overbought or oversold for a long period of time.