The relative strength indicator is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. It is calculated using the following formula:
RSI = 100 – 100/(1 + RS*)
*Where RS = Average of x days’ up closes / Average of x days’ down closes.
As you can see from the chart, the RSI ranges from 0 to 100. An asset is deemed to be overbought once the RSI approaches the 70 level, meaning that it may be getting overvalued and is a good candidate for a pullback. Likewise, if the RSI approaches 30, it is an indication that the asset may be getting oversold and therefore likely to become undervalued.
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. The RSI is best used as a valuable complement to other stock-picking tools.
Determining the true value of an oscillator depends on the understanding of overbought or oversold positions. There has always been a little confusion over the difference between relative strength, which measures two separate and different entities by means of a ratio line, and the RSI, which indicates to the investor whether an issue’s price action is created by those overbuying or overselling it. The formula for the RSI is as follows:
At the bottom of the chart below, the RSI, on a scale of 0-100, indicates that the overbought position is at 70 and the oversold position is at 30. An investor may choose to reset the indicators’ parameters to 80 and 20. This helps the investor be sure when making the decision to buy or sell an issue, and not “pull the trigger” too fast.
Some trader’s have found that the RSI works best when it’s compared to short-term moving-average (MA) crossovers. Using a 10-day MA with a 25-day MA, you may find that the crossovers indicating a shift in direction will occur very close to the times when the RSI is either in the 30/70 or 20/80 range; the times when it is showing either distinct overbought or oversold readings. Simply put, the RSI, sooner than almost anything else, indicates an upcoming reversal of a trend, either up or down.
“Failure swings” may help investors take the maximum advantage of the information provided by the RSI. The 30/70 on our scale represents the oversold/overbought positions. It is important to understand that an overbought or oversold position can remain in an extended uptrend or downtrend for some time. Traders should watch the volume indicators in the instances when the RSI has an extended showing either at the 30 or 70 level. This helps the investor determine if the interest in the issue is waning, and whether traders are now starting to take profits at the top end or starting to accumulate at the bottom end. Prior to using this tool to determine his or her own buy and sell entry points, a new investor should study old charts to see the kinds of price action that occurs at the top and bottom ends of the RSI scale.