Trading Signals with the RSI
Get to grips with the relative strength index (RSI), a vital momentum indicator used in technical analysis to assess the market momentum of an asset and understand if it has been overbought or oversold.
Momentum Indicators – RSI
The Relative Strength Index (RSI) is a popular momentum indicator used by traders looking at technical analysis. The RSI is an “oscillator” indicator that moves between the values of 0 to 100. It can help to signal the current state of the price, such as overbought/oversold conditions and the strength of the trend. The RSI is useful across several time horizons.
The RSI looks at the number of periods (such as days, hours, etc.) across a given time frame in which price has risen, compared to the number of periods that the price has fallen. The formula then calculates where the price is trading relative to the range over the period in question.
In the original study, Welles Wilder (the inventor of the RSI) used 14 periods as the optimum number to use. While it is possible to use other periods, it is generally accepted that 14 is the norm for traders to use. So, for example, on a daily chart, the 14 -day RSI would be used. On an hourly chart, 14 hour RSI would be used.
As we said earlier, the parameters can be adjusted to meet the needs of the user. Shorter-term traders may like to use fewer periods when calculating the RSI, with the 9-period RSI often a popular calculation. Reducing the number of periods in the calculation will result in increased sensitivity/volatility of the indicator. This can result in more signals with quicker moves into the overbought/oversold territories. However, the caveat is that it increases the potential for false signals.
Using an adaptation from the original Welles Wilder formula, the RSI can be calculated as:
RSI = 100 - 100 / 1+RS
Where RS = The average gain over the number of periods divided by the average loss over the number of periods
The formula calculates a number in a range between 0 and 100. Broadly speaking a reading above 70 is used to suggest that the price is overbought, while a reading below 30 is used to suggest that it is oversold.
Be careful not confuse the RSI (Relative Strength Indicator) with the Relative Strength Ratio
One of the reasons why the RSI is known by its acronym is to avoid confusion with the Relative Strength Ratio, which is an indicator that measures the performance of one instrument relative to another.
Reading the RSI
The RSI oscillates between 0 and 100, with 50 considered to be the neutral, or mid-point. If the RSI is above the 50-level and advancing, momentum over the period being studied is considered to be positive. Conversely, if the RSI is below 50 and in decline, momentum over the period being studied is considered to be negative.