What is the Relative Strength Index (RSI)?
The relative strength index (RSI) is a momentum indicator used in technical analysis that measures the magnitude of recent price changes to evaluate overbought and oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator and can have a reading from 0 to 100, originally developed by the famed mechanical engineer turned technical analyst, J. Welles Wilder.
Traditional usage of the RSI is that values of 70 or above indicate that an asset is becoming overbought or overvalued and may be primed for a trend reversal or pullback. On the other hand, an RSI reading of 30 or below indicates the asset or security is oversold or undervalued in price.
How to Calculate the RSI
Calculation of the RSI, to be done thoroughly, requires a great deal of highly technical and complex explanations. To fully understand how the calculation is accomplished, traders and analysts should read Wilder’s own explanation. It is presented in his 1978 book, New Concepts in Technical Trading Systems.
However, the index can be broken down into a (fairly) simple formula:
RSI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change)]
Example of Relative Strength Index (RSI)
Looking at the 2D time frame of BTC (Bitcoin) we can see that during the dump of early 2020 that the RSI dipped below 30, indicating that the price of the asset was oversold and a reversal is on the way. As the price of Bitcoin continued to rise, the RSI index topped 70 a few times and is currently hovering above that area. Now that it’s been over 70 for some time, traders can expect that a sell off will take place soon to reset the index back to 30 before moving higher.
How to Trade based off the RSI
Many traders use the 30-70 rule for trading the Relative Strength Index (RSI). Traders know that the price of the asset is oversold at or underneath 30 and will scoop up the asset or security at a discounted rate. On the other hand, traders know that when the RSI has a reading of 70 or higher, they’ll start to look for prices to exit and sell off the asset or security before the dump really starts taking form.
During uptrends, the RSI tends to remain more static than it does during downtrends. This makes sense because the RSI is measuring gains versus losses. In an uptrend, there will be more gains, keeping the RSI at higher levels. In a downtrend, the RSI will tend to stay at lower levels.
During an uptrend, the RSI tends to stay above 30 and should frequently hit 70. During a downtrend, it is rare to see the RSI exceed 70, and the indicator frequently hits 30 or under. These guidelines can help determine trend strength and spot potential reversals. For example, if the RSI isn’t able to reach 70 on a number of consecutive price swings during an uptrend, but then drops below 30, the trend has weakened and could be reversing lower.
The reverse is true for a downtrend. If the downtrend is unable to reach 30 or below and then rallies above 70, that downtrend has weakened and could be reversing to the upside.
What is the Stochastic RSI (Stoch RSI)?
The Stochastic RSI (StochRSI) is an indicator used in technical analysis that ranges between zero and one (or zero and 100 on some charting platforms) and is created by applying the Stochastic oscillator formula to a set of relative strength index (RSI) values rather than to standard price data. Using RSI values within the Stochastic formula gives traders an idea of whether the current RSI value is overbought or oversold.
The StochRSI oscillator was developed to take advantage of both momentum indicators in order to create a more sensitive indicator that is attuned to a specific security’s historical performance rather than a generalized analysis of price change.
Limitations of the RSI
The RSI compares bullish and bearish price momentum and displays the results in an oscillator that can be placed beneath a price chart. Like most technical indicators, its signals are most reliable when they conform to the long-term trend.
True reversal signals are rare and can be difficult to separate from false alarms. A false positive, for example, would be a bullish crossover followed by a sudden decline in a stock. A false negative would be a situation where there is a bearish crossover, yet the stock suddenly accelerated upward.
Since the indicator displays momentum, it can stay overbought or oversold for a long time when an asset has significant momentum in either direction. Therefore, the RSI is most useful in an oscillating market where the asset price is alternating between bullish and bearish movements.