Relative Strength Index

The Relative Strength Index (RSI) is a momentum oscillator commonly used in the technical analysis of financial markets. It is designed to measure the speed and change of price movements.

Definition

The RSI compares bullish and bearish price momentum and is typically used to identify overbought or oversold conditions in a trading instrument. The index is plotted on a scale of 0 to 100 and is considered overbought when above 70 and oversold when below 30.

Calculation

The RSI is calculated using the following steps:

1. Average Gain and Average Loss: Over a chosen period, typically 14 days, calculate the average gain and average loss. This is done by summing all the gains and losses (on days when the price closed higher or lower than the previous day, respectively) and dividing them by the period.

2. Relative Strength (RS): Calculate the Relative Strength (RS), which is the ratio of average gain to average loss.

RS =Average Gain / Average Loss​

3. Relative Strength Index (RSI): Use the RS to calculate the RSI.

RSI = 100 − (100 / 1+RS)​

Example

Let’s calculate the RSI for a hypothetical asset over a 14-day period. Assume the following daily price changes:

• Gains: $1, $2, $1.5, $0.5, $3 (5 days with gains)
• Losses: $-0.5, $-1, $-1.5, $-0.75, $-2.5, $-0.25, $-1 (7 days with losses)

1. Calculate Average Gain and Average Loss:

Average Gain = (1 + 2 + 1.5 + 0.5 + 3 ) / 14 ≈0.571

Average Loss = (0.5 + 1 + 1.5 + 0.75 + 2.5 + 0.25 + 1 ) / 14 ≈ 0.464

2. Calculate RS:

RS = 0.571 / 0.464 ≈ 1.231

3. Calculate RSI:

RSI = 100 − (100 / 1 + 1.231 ) ≈55.17

So, the RSI for this 14-day period is approximately 55.17.

Usage in Financial Analysis

• Overbought and Oversold: RSI levels above 70 suggest an overbought condition (potential sell signal), while levels below 30 indicate an oversold condition (potential buy signal).
• Divergences: A divergence occurs when the price of an asset makes a new high or low that is not reflected in the RSI, often indicating a potential reversal.
• Centerline Crossover: Movement of RSI above 50 can signal a bullish trend, while movement below 50 can indicate a bearish trend.

It’s important to note that RSI should not be used in isolation. False signals are common, and it’s best used in conjunction with other technical analysis tools and methods.