Before we start our discussion about Relative Strength Index, let us explain briefly what Oscillators are.
Oscillators are one of the indicators that are used in technical analysis. They are used in viewing charts that are non-trending. An oscillator can remain at extreme levels for an extended period. However, it could not trend for a sustained period.
Click here to learn more about Oscillators.
Now that you have basic knowledge about Oscillators, let’s go and discuss RSI.
History of Relative Strength Index (RSI)
Welles Wilder is the one who developed the Relative Strength Index or RSI. He even included RSI in his book entitled “New Concepts in Technical Trading Systems” which was published in the year 1978.
RSI was also featured in a few articles, interviews, and books over the years. A particular one is the book of Constance Brown which is called “Technical Analysis for the Trading Professional.” In the book, it featured the concept of bull market and bear market ranges for RSI.
Another one is Andrew Cardwell, who is the mentor of Brown’s RSI. He introduced the positive and negative reversals for RSI.
Now, since you have learned a brief history of RSI, let’s go and dig a little deeper and learn what RSI is all about.
RSI is a specific kind of Oscillator, and is one of the most frequently used. It measures the speed and the change of movements in prices.
It is also a well-known momentum indicator in technical analysis. RSI oscillates between 0 and 100.
It is also used to signal overbought and oversold conditions in a security. In addition, according to Wilder, RSI is considered overbought when it is above 70 and it is considered oversold when it is below 30.
How to Use RSI
Okay, just like other indicators, there are two general ways wherein the indicator is used to generate signals. These are the crossovers and divergence.
You should take note that in the case of the RSI, the indicator uses crossovers of its overbought, oversold, and centerline.
Now, for the first technique, you have to use overbought and solid lines to generate buy-and-sell signals. In the RSI, the line where overbought is typically located is at 70.
For additional information, these values can be changed to either increase or decrease the number of signals that are formed by the RSI.
And as for buy signal, it is generated when the RSI breaks the oversold line in an upward direction, which means that it goes from below the oversold line to moving above it.
Meanwhile, a sell signal is formed when the RSI breaks the overbought line in a downward direction crossing from above the line to below the line.
You can also use a more conservative approach by setting the overbought and oversold levels at 80 and 20, respectively.
Next technique is the crossover. This is used in formulating signals by using the centerline, which is 50. This technique is just the same as the overbought and oversold lines to formulate signals. You should know that this technique often forms signals after a movement in the direction they are predicting.
These signals are often used as a confirmation than a signal compared to the other strategies.
Another thing to remember, a downward trend is confirmed when the RSI crosses from above 50 to below 50.
On the other hand, an upward trend is confirmed when the RSI crosses above 50.
Now, let us further explain the formula of this indicator to you.
To simplify it, the RSI has been broken down into its basic components. These components are RS, Average Gain, and Average Loss.
This calculation of RSI is based on the 14 periods, which is the default, according to Wilder’s book. It is also important to know that losses are expressed as positive values and not negative values.
The very first calculations for average gain and average loss are simple 14-period averages.
- First Average Gain = Sum of Gains over the past 14 periods / 14.
- First Average Loss = Sum of Losses over the past 14 periods / 14
Meanwhile, the second and subsequent calculations are based on the prior averages and the current gain loss.
- Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
- Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.
Taking the prior value plus the current value is a smoothing technique, which is similar to that used in calculating an exponential moving average.
This also means that the values of RSI become more accurate as the calculation period extends.
Relative Strength Index is one of the indicators that have stood the test of time. It has remained relevant today just like before.
It may seem hard at first, but once you get around to learning the ins and outs of Relative Strength Index, it will just be easy.
The key point here is to learn about all the indicators that can help you in the field of investing.
It may take time and hard work to know all of them. Remember the saying: no pain, no gain!