The Relative Strength Index (RSI) is a technical momentum indicator that compares recent gains to recent losses in an attempt to determine wether a stock is overbought or oversold. It does this by indicating changes in momentum which in turn may signal imminent price changes.
The basic formula used to calculate the RSI is:
RSI = 100 – [100/(1+ RS)]
where RS = Average Gain/Average Losses
and Average Gain = Total Gains/ no. of periods
Average Loss = Total Loss/ no of periods
It should be pointed out that depending on the charting package used there might be slight variarions to this formula, but the basic principal remains the same.
For short-term trading, a time scale of fourteen (14) days is often used.
Application - It is easy to use in practice.
An RSI level of 70 or above would indicate that the stock is overbought (it may be getting overvalued and is ready for a pullback) and a level of 30 or below would indicate oversold (and therefore likely to become undervalued). In practice, when the RSI is above or close to 70 and starts to fall, there is a possibility of short-term
bearish momentum and when the RSI is below or close to 30 and rises, there is the possibility of short-term
bullish momentum.
For some technical analysts, when the RSI rises through 50 from the 30 region it is bullish and coversely if it falls through the 50 from the 70 region it is bearish.
Divergence is another popular technique used by traders . Divergence is when the RSI indicator and the stock price are moving in opposing directions. For example, when the RSI has risen from a low level (from 20 to 60) and the stock price is decreasing, it may suggest the stock price may break out of its its downtrend and reverse to match up to the RSI.
The daily chart, above, shows how the RSI can be used around the "70" and "30" line. You can see that points 1,2 and 4 touch or cross below the 70% RSI and the corresponding share price reduces, while on the other hand point 3 shows that once the 30% RSI is broken the corresponding share price rises. A trader using RSI should be aware that large surges and drops in the price of an asset will affect the RSI by creating false buy or sell signals. Like all indicators, the
RSI should be used in conjunction with aother analysis.