RSI Indicator: Meaning & Calculation
Knowing what the relative strength index (RSI) is and knowing how to read an RSI chart are invaluable tools investors can use to spot trend reversals.
What Is Relative Strength Index In Stocks?
The relative strength index (RSI) is a technical indicator that measures the momentum of a security based on its closing prices. Once calculated, the RSI is displayed as an oscillator, which is a line graph between two extreme values. In the case of RSI, those extremes are 0 and 100.
In stocks, the relative strength, or RS, is the ratio of higher closes to lower closes, and the RSI is the ratio of higher closes to overall closes. The RSI is typically based on a 14-day time frame with high values being 70 or above, and low values being 30 or below. Levels such as 80 or 20 indicate a stronger trend in upward or downward momentum, respectively.
RSI was first introduced by American technical analyst J. Welles Wilder Jr. in his 1978 book, New Concepts in Technical Trading Systems. Taking into account both an asset's price and its trading volume, investors use RSI to determine whether a stock is overbought or oversold:
- Overbought: The price of an asset, such as a stock, is above its fair or intrinsic value and may be ready for a trend reversal; on an RSI chart it appears at 70 or above.
- Oversold: The price of an asset, such as a stock, is below its fair or intrinsic value and may be ready for a trend reversal; on an RSI chart it appears at 30 or below.
It is when an RSI chart is paired along with a stock's price chart that identifiable patterns begin to emerge in the data.
How to Read RSI
Let's take a look at the RSI chart for Microsoft Corp. covering the period beginning on September 20, 2021 and ending on June 9, 2022.
The chart tells us that the stock spent part of October 2021 in overbought territory and entered that territory again briefly in February 2022. MSFT was in oversold territory or was undervalued, in December 2021.
It is when a stock's RSI chart is displayed alongside its price chart, and the two share the same timeline running along their x-axis, that powerful patterns begin to appear. These patterns display a security's momentum against its price.
How the RSI Is Calculated
The data points on an RSI chart are calculated by using the following two formulas:
RS = Average Gain / Average Loss
RSI = 100 - (100 / (1+RS))
- To calculate the RSI, we must first calculate the Relative Strength, or RS, which is equal to the Average Gain divided by the Average Loss.
- To determine the Average Gain, we must first calculate the Initial Average Gain, and we do that by summing all the price gains that have occurred over the last 14 days; 14 is the number of periods recommended by Wilder, and we divide that number by 14.
- We calculate the Initial Average Loss by summing all the price losses over the last 14 days and then dividing by 14; loss is always a positive number because it reflects a quantity.
Initial Average Gain = Sum of Gains over the past 14 days / 14
Initial Average Loss = Sum of Losses over the past 14 days / 14
- For each subsequent day's gain, we calculate the Average Gain and the Average Loss by using these two formulas:
Avg. Gain = [(Previous Avg. Gain * 13) + Current Day's Gain] / 14
Avg. Loss = [(Previous Avg. Loss * 13) + Current Day's Loss] / 14
- If the Average Gain equals zero, it means that prices moved lower during all 14 periods, and the RSI will also be equal to zero.
- If the Average Loss equals zero, that means that prices moved higher during all 14 periods, and the RSI will equal 100 by definition, bypassing the mathematical problem of division by zero.
- This calculation technique smooths the values and each value becomes more accurate as the number of periods increases.
- The RSI will increase if the number of positive closes increases and if the magnitude of those closes increases.
- The RSI will decrease if the number of negative closes increases and if the magnitude of those closes decreases.
RSI Calculation Example
Let's assume that over the last 14 days a stock closed higher on seven days, with an average gain of 2%. That means that the stock closed lower on seven days and its average loss is 1%. Plugging those figures into the two formulas, we get:
RS = 0.02 / .01 = 2
RSI = 100 - 100 / (1 + 2) = 66.67
If we plot that data point into an RSI chart, we can see that the stock in this example is close to overbought territory.
What The RSI Tells Investors
In general, a relative strength index tells investors that:
- A reading above 30 is viewed as a bullish indicator.
- A reading below 70 is viewed as a bearish indicator.
- A reading of 80 and above is a strong indicator of an overbought condition.
- A reading of 20 and below is a strong indicator of an oversold condition.
- Overbought assets may be ready for a correction or a trend reversal.
- Oversold assets may be ready for price breakouts.
- There are identifiable points where an investor can enter a position.
Important: Technical analysis patterns represent past price movement only. Using past price movement to predict future price movement involves a high level of risk. This article does not recommend that investors make decisions on technical analysis alone. It's simply one tool that investors can use to make more informed investment decisions.
Bullish RSI Divergence
Divergences occur when the RSI moves in a direction opposite to that of prices and they can be identified by comparing the two charts.
A bullish divergence occurs when:
- On the price chart, prices fall to lower lows, identified by a downward sloping line connecting the lows.
- On the RSI chart, lows move higher, identified by an upward sloping line connecting the lows.
Together, these two conditions indicate rising bullish momentum.
Bearish RSI Divergence
A bearish divergence occurs when:
- On the price chart, highs move higher identified by an upward sloping line connecting the highs.
- On the RSI chart, highs move lower, identified by a downward sloping line connecting the highs.
Together, these two conditions indicate rising bearish momentum.
MACD vs. RSI
MACD stands for moving average convergence divergence and it is a measure of the strength of a stock's price movements. It does this by comparing the divergence of two EMAs, or exponential moving averages, one a 12-period, and one a 26-period. Traders can then compare the scope of recent price changes with the scope of those that took place earlier.
By comparison, RSI is a measure of the strength of a stock's momentum, either in the upward or the downward direction, and it identifies either overbought or oversold conditions.
Pros & Cons of Using the RSI
Pros
- The RSI works best when an asset's price is moving up or down, or oscillating, rather than continuing on a trend.
- The RSI is a reflection of the speed at which the price of a security is being bid up or down.
Cons
- Because the RSI is measuring momentum, it can remain in either overbought or oversold territory despite trend reversals beginning to take shape.
- While RSI readings below 30 might generate a "buy signal", the asset's downward trend might continue for a long time before it reverses course.
Bottom Line
Because it measures the speed and size of an asset's momentum, changes in the RSI along with changes in the price chart can be a powerful indicator of trend reversals. However, it isn't able to tell investors exactly when those reversals will take place and what those price changes will be.
Together with the MACD, the RSI is another useful tool in an investor's toolbox.
This article was written by
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