Relative Strength Index is a momentum indicator measuring and simplifying price movement. It identifies when stock is overbought or oversold. These gives entry and exit signals; but equally valuable, RSI serves as both a confirmation tool and as an early reversal signal that is confirmed by other technical signs.
One advantage to using RSI is that with many free online charts, it can be programmed in and calculated automatically. It isn't necessary to go through the steps; but it makes sense to know how the calculation is performed.
First, calculate the average of upward and downward-moving days over the past 14 sessions. The formula (with 'U' representing the average number of upward-moving days over 14 trading days, and 'D' representing the average number of downward-moving days):
100 - [ 100 ÷ ( 1 + ( U ÷ D ) ) ] = RSI
For example, over the past 14 sessions, there were nine upward-moving days and five downward-moving days:
U = ( 9 ÷ 14), or 0.64
D = ( 5 ÷ 14), or 0.36
100 - [ 100 ÷ ( 1 + ( 0.64 ÷ 0.36 ) ) ] =
100 - [ 100 ÷ ( 1 + 1.78 ) ] =
100 - [ 100 ÷ 2.78 ] =
100 - 36 = 72
In this case, RSI has a value of 72. Under the usual assumptions accompanying the calculation, an RSI above 70 is overbought; and an RSI below 30 is oversold. So this outcome reveals the probability that the stock is overbought and is due for a downturn.
This is a simplification. Momentum indicators are only pieces of the larger puzzle, and need confirmation. RSI measures the speed of change but does not offer a guarantee that reversal is impending. RSI works best when used to confirm what you see in traditional price patterns, candlestick formations, or in combinations of both.
RSI, especially by itself, can be misleading. This is especially true when a very strong trend is underway. An overbought condition in a strong uptrend (or oversold in a strong downtrend) does not always signal reversal. For this reason, RSI cannot be relied upon by itself, but needs to be put to work with a range of other price and momentum measurements.
In a strong bull market, some experts recommend adjusting the RSI levels. For example, RSI is likely to fluctuate between 40 and 90 (rather than 30 to 70) in a strong bull market, with the range of 40-50 the support levels. The same rule works in reverse, with bear market adjustments of RSI to between 20 and 60, with the 50-60 level as resistance.
Momentum indicators are estimates, which is why confirmation is crucial. In that respect, RSI is probably more valuable for confirming other signals that serving as a leading indicator. It is most effective when used in conjunction with well-understood and strongly developed candlestick patterns. If nothing else, RSI serves as one of many valuable additions to a technician's toolbox.
To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more.
I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.