What is Relative strength index(RSI)?
It measures the speed and magnitude of a security or index’s recent price changes to know overvalued or undervalued conditions in the price of that security or index. RSI is one of indicator that is widely used in Technical analysis of stock or index.
Apart from identifying overbought and oversold zone, the Relative strength index(RSI) can also indicate securities that can shift for a trend reversal or a corrective pullback in price. It can signal when to buy and sell. Normally, The RSI reading of 70 or above indicates an overbought zone. A reading of 30 or below indicates an oversold zone.
Formula of Relative strength index
RSI = 100 – [100 / (1 + RS)]
Where:
- RS = Average Gain / Average Loss
- Gain: Closing price increases
- Loss: Closing price decreases
Example RSI Calculation:
Example of Stock Prices for 14 Days:
500, 505, 495, 510, 512, 507, 515, 518, 513, 520, 530, 527, 535, 533
Step 1: Calculate Daily Gains and Losses
- Day 1: 505 – 500 = +5 (gain)
- Day 2: 495 – 505 = -10 (loss)
- Day 3: 510 – 495 = +15 (gain)
- Day 4: 512 – 510 = +2 (gain)
- Day 5: 507 – 512 = -5 (loss)
- Day 6: 515 – 507 = +8 (gain)
- Day 7: 518 – 515 = +3 (gain)
- Day 8: 513 – 518 = -5 (loss)
- Day 9: 520 – 513 = +7 (gain)
- Day 10: 530 – 520 = +10 (gain)
- Day 11: 527 – 530 = -3 (loss)
- Day 12: 535 – 527 = +8 (gain)
- Day 13: 533 – 535 = -2 (loss)
Step 2: Separate Gains and Losses
- Total Gains: 5, 15, 2, 8, 3, 7, 10, 8 = 58
- Total Losses: 10, 5, 5, 3, 2 = 25
Step 3: Calculate Average Gain and Average Loss
- Average Gain = 58 / 14 = 4.14
- Average Loss = 25 / 14 = 1.79
Step 4: Calculate the Relative Strength (RS)
RS = Average Gain / Average Loss
RS = 4.14 / 1.79 ≈ 2.31
Step 5: Calculate the RSI
RSI = 100 – [100 / (1 + RS)]
RSI = 100 – [100 / (1 + 2.31)]
RSI = 100 – [100 / 3.31]
RSI ≈ 100 – 30.21
RSI ≈ 69.79
Conclusion:
In this example, the 14-day RSI is approximately 69.79, which indicates the stock is approaching overbought conditions (close to 70). If it crosses 70, it would suggest that the stock is overbought and might be due for a pullback.
We must make note that RSI above 70 does not always implies that it will start correcting on same if it is below 30 it does not always implies upward movement. One should also consider some other indicators to support a downtrend or uptrend; some of the widely used such indicators are listed below.
1 Golder cross OR Death cross
2 Moving Average Convergence Divergence (MACD)
3 On-Balance Volume (OBV)
4 Stochastic Oscillator
5 Bollinger Bands
Key takeaways of relative strength index
- Identifies Overbought and Oversold Conditions: RSI values above 70 indicate an overbought condition (potential price correction), while values below 30 suggest an oversold condition (potential price rebound).
- Measures Momentum: Relative strength index(RSI) tracks the speed and magnitude of recent price movements, helping traders understand if a stock is gaining or losing momentum.
- Divergence Signals: Relative strength index(RSI) divergence (price moving one way and RSI moving another) can signal a potential trend reversal—bullish divergence in oversold regions and bearish divergence in overbought areas.
- Customizable Time Periods: While the default RSI period is 14 days, traders can adjust the period to suit their strategy—shorter periods (e.g., 7 days) make RSI more sensitive, and longer periods (e.g., 21 days) make it smoother.
- Used in Conjunction with Other Indicators: RSI should be combined with other technical indicators, like moving averages or trendlines, to confirm trading signals and avoid false readings.
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