The relative strength index - or 'RSI' for short - is a powerful and highly adaptive trading tool that can be applied to a chart of any index or stock. As with all tools, the RSI indicator offers advantages as well as drawbacks. Skilled investors, however, will be able to minimize those drawbacks and maximize the advantages of the relative strength index, and use the tool to enhance his or her overall returns.
RSI Explanation
The relative strength index falls into the oscillator family of indicators, as it plots the strength of a stock's or index's movement on a scale between 0 and 100; 0 is the weakest reading, while 100 is the strongest reading. The RSI reading changes day-to-day, and as such, appears to rise and fall over time. Interpreting the movement of the RSI line as it travels between 0 and 100 is the key to its successful usage as a trading tool.
RSI Formula
As with most technical analysis indicators, knowing the underlying formula for the underlying indicator is not necessary, nor is it as important as understanding how to interpret the indicator. Nevertheless, knowing precisely how a tool works can only better equip the trader to use that tool.
To that end, the formula to calculate the day-to-day relative strength index score is as follows:
- RSI = 100 - (100/(1 + RS*))
- *RS = ( (sum of closing prices of up day/n**) / (sum of closing prices of down days/n**) )
- **n = trading periods
As the formula indicates, the number of trading periods used in the calculation of the RSI score can be adjusted to make it less volatile (which makes it slower to provide signals), or make it faster (which makes it more prone to give errant signals). That speed/accuracy trade-off is characteristic of all technical indicators.
Using the Relative Strength Index
The obvious interpretation of the RSI tool is also the most common one. For instance rising RSI line is generally bullish, while a falling RSI line is considered a bearish indication. That said, an excessively high relative strength index level is typically the result of persistently high prices, or a rapid runup in a stock's price. As such, an RSI reading that is 'too high' (usually over 80) is also considered to be 'overbought'. That stock or index is ripe for a pullback.
Conversely, a relative strength score that is 'too low' (usually under 20) is generally the result of an oddly-persistent wave of selling, or a dramatic dip in a stock's or index's price level. In those cases, the 'oversold' instrument is poised for a strong, upside bounce.
Tips for Using the RSI Indicator
- As with all technical indicators, RSI is a way of measuring odds - it's not a full-blown, fool-proof trading 'system'. It is usually best used in conduction with other indicators.
- Though considered an oscillator, the relative strength index has qualities of momentum indicators, and can be used in that capacity. For instance, some traders interpret a cross of the 50 level (the mid-point of the scale) as a signal of momentum - bullish or bearish - in itself.
- The RSI oscillator should not be confused with another trading tool also - and unfortunately - called the relative strength index. The other tool compares a stock's or index's performance to other stocks or indices in a group, and ranks that stock or index, assigning a 'relative strength' score. The other tool is a powerful tool too, but is unrelated to the RSI indicator discussed here.
Related Reading
- Chart Analysis Using Fibonacci Retracement Lines
- Free Online Stock Charting Software
- Candlestick Chart Patterns - Harami, Engulfing
James Brumley - As a former stock broker and analyst, turned writer, James Brumley can tell you what most advisors can't - or won't. His belief is that ...
