RSI Indicator: Definition, Formula, and Trading Insights
Developed by John Welles Wilder Jr., the Relative Strength Index (RSI) is a popular technical indicator traders use to analyze momentum and identify potential overbought and oversold conditions in financial markets.
By measuring the speed and magnitude of price movements, the RSI generates a score between 0 and 100, helping traders make more informed decisions. Here’s how it works:
Key takeaways
The Relative Strength Index (RSI) is a trend-following technical indicator that fluctuates between 0 and 100, providing traders with buy and sell signals.
Key levels to watch are the oversold zone (0 to 30), overbought zone (70 to 100), and the median line (50), which traders monitor to analyze market conditions.
The RSI is not a miracle indicator. Its predictive ability is still debated, but remains one of the most widely used trading tools today.
Trading exposes you to the risk of losing more than your initial investment and incurring financial liability. Trading is suitable only for well-informed, sophisticated clients able to understand how the products being traded work and having the financial ability to bear the aforementioned risk.
Transactions involving foreign exchange instruments (FOREX) and contracts for difference (CFD) are highly speculative and extremely complex. As such, they are subject to a high level of risk due to leverage. Please keep in mind that CFD trading is banned in the US.
Information published on the NewTrading.io website is for informational purposes only and should not be construed as offering investment advice or as an enticement to trade financial instruments.
What is the RSI?
The Relative Strength Index (RSI) is a trend-following technical indicator.
As one of the most popular technical indicators, the Relative Strength Index (RSI) is a tool that traders use to measure how quickly and by how much the price of a stock (or any financial asset) is changing. The strength of price movements helps to identify potential overbought or oversold conditions that might signal a trend reversal.
Invented in 1978 by J. Welles Wilder and introduced in his book “New Concepts in Technical Trading Systems,” the RSI is an oscillator that ranges between 0 and 100.
Its oversold zone (0 to 30), overbought zone (70 to 100), and median line (50) give traders buy and sell signals.
First, a mechanical engineer and then a real estate developer, John Welles Wilder Jr. eventually pursued a career as an inventor of technical indicators in a small New Zealand village far from Wall Street. In addition to the RSI, he created numerous technical indicators, including ATR, ADX, and SAR.
Understanding RSI
The RSI compares the strength of recent price gains to that of recent losses over a given period.
| RSI Value | Implication |
|---|---|
| Average of recent gains = Average of recent losses (RSI = 50: Balance between buyers and sellers.) | No clear upward or downward momentum in the market. |
| Average of recent gains > The average of recent losses (RSI > 50: More buyers than sellers) | Bullish momentum |
| Average of recent gains < Average of recent losses (RSI < 50: Fewer buyers than sellers) | Bearish momentum |
The RSI doesn’t just show who’s leading—buyers or sellers. It helps you see how this balance shifts over time, giving you insight into upcoming market trends.
| RSI Behavior | Implication |
|---|---|
| The RSI moves towards its upper limit (100) | The upward trend is getting stronger and more consistent. This typically suggests strong buying pressure as the market perceives the asset as being potentially undervalued. |
| The RSI moves towards its lower limit (0) | The downward trend is getting stronger and more consistent. This generally indicates strong selling pressure, possibly because the market views the asset as overvalued. |
By watching the RSI, traders can figure out:
- Is the advantage for buyers getting stronger or weaker?
- Is this buyer advantage unusually high compared to what’s happened before?
- Are we near a level that the market often returns to when it takes a break from its primary trend?
How to configure the RSI
The RSI has only one setting, called ‘n,’ which tells you how many time periods the tool should look at.
For example, RSI(14) checks the price changes over the last 14 time periods, which means the last 14 days if you’re looking at a daily chart.
While RSI(14) is the standard and most commonly used setting, traders can adjust it to shorter or longer time frames based on their specific needs, such as RSI(9) or RSI(25).
Choosing a shorter period, like 9, means the RSI will respond faster to price changes, which can make it look erratic. If you go for a longer period, like 25, the RSI will gradually change and appear steadier. Traders choose shorter or longer RSI periods based on their need for speed and frequency of trading signals versus their preference for stability and clarity in trend analysis.
How to read the RSI while Trading?
The RSI (Relative Strength Index) can significantly enhance your market analysis. Here’s how to interpret its various elements.
Understanding the RSI Median line
The Relative Strength Index (RSI) median line is set at the 50-point mark. When the RSI touches this line, it indicates that the forces between buyers and sellers are perfectly balanced.
This midpoint is typically reached during markets without a clear trend or when a trending market takes a break.
In an uptrend, it’s normal for prices to go through a correction that brings the RSI down to this 50-point line. Reaching this level often signals that the correction might be over and that prices could start rising again.
In this case, investors might consider the median line a support level, which could kickstart a new rally.
In a downward trend, prices can start to rebound, and the RSI may rise back up to the median line. At this point, the median line may act as resistance, potentially leading to a new downward impulse.
Oversold and Overbought RSI
By default, the RSI’s oversold zone is set between 0 and 30, while the overbought zone is between 70 and 100.
Some traders may choose to expand or narrow these zones. It’s not uncommon to see RSIs with the oversold zone adjusted between 0 and 20 and the overbought zone between 80 and 100 to filter trading signals further, making the indicator less sensitive.
RSI Divergences
An RSI divergence occurs when the stock price and the RSI indicator move in opposite directions. This pattern signals a weakening of the current trend and the potential proximity of a trend reversal.
Bullish Divergences happen when prices form increasingly lower lows while the RSI does not decrease or even begins to rise. This setup suggests that despite the declining prices, the underlying momentum is becoming more positive, indicating a potential upcoming bullish reversal.
Bearish divergences occur when prices form increasingly higher highs while the RSI does not follow or even decreases. This setup indicates that despite the rising prices, the underlying momentum is weakening, suggesting a potential upcoming bearish reversal.
RSI Buying and selling signals
| In an uptrend | On a downward trend | |
|---|---|---|
| Buying Signal | RSI is above median line. The RSI leaves the oversold zone and starts to rise (early signal). The RSI is back on the median line, which acts as support. | RSI crosses the median line upward. RSI enters the oversold zone (early signal). The RSI exits the oversold zone (confirmation of the early signal). Formation of a bullish divergence |
| Selling Signal | RSI crosses below the median line downward. RSI enters the overbought zone (early signal). RSI exits the overbought zone (confirmation of the early signal). Formation of a bearish divergence. | The RSI moves below its median line. The RSI bounces back up to the median line, which acts as resistance. |
Chart patterns used for price analysis, such as support, resistance, and channels, can also be applied to analyze the RSI. However, it’s important to remember that the RSI does not directly represent prices but rather the strength and speed of price movements.
How is the RSI calculated?
\text{RSI} = 100-(\frac{100}{1+\frac{G}{L}}) Where:
- G = average of price gains over the last n last periods
- L = average of price loss over the last n last periods
Let’s take the example of an RSI with 14 days applied to a stock whose historical performance is as follows:
| Trading Session | Performance |
|---|---|
| 1 | +3% |
| 2 | -1% |
| 3 | +2% |
| 4 | -1% |
| 5 | +4% |
| 6 | -2% |
| 7 | +10% |
| 8 | -1% |
| 9 | +5% |
| 10 | -3% |
| 11 | +15% |
| 12 | -1% |
| 13 | -1% |
| 14 | -1% |
To calculate the RSI for this stock, start by calculating the average gains and average losses over the last 14 sessions.
\text{Average gains} = \frac{3 + 2 + 4 + 10 + 5 + 15}{6} = 6.5\text{Average losses} = \frac{1+1+2+1+3+1+1+1}{8} = 1.375Next, calculate the RSI using its formula.
\text{RSI} = 100 - (\frac{100}{1 + \frac{6,5}{1,375}}) = 82,54The RSI(14) for this stock is 82.54.
Top trading platforms automatically calculate the RSI and display it as a line right below the stock chart.
RSI advantages and limits in Trading
Pros
- Relatively easy to use and interpret, even for beginner traders
- Its popularity can sometimes create a self-fulfilling prophecy
- Can help identify overbought and oversold condition
Cons
- Can generate false signals or delayed signals that might mislead traders
- No scientifically proven predictive ability
- Default settings may need adjustment based on the trader’s time frame (very sensitive on smaller time frames)
The Relative Strength Index (RSI) is essential in technical analysis. Beginner traders often start by learning the RSI and understanding its trading signals before moving on to other popular indicators.
You can use a free real-time trading simulator with virtual money to practice trading with the RSI without risk.
FAQ
Should you buy when the RSI is low?
A low RSI in the oversold zone (between 0 and 30) indicates strong selling pressure. This might suggest a buying opportunity, but be careful, as stock prices can continue to fall even after entering the oversold zone. Some traders prefer to wait for additional confirmation signals, like the RSI exiting the oversold zone, before buying.
Should you sell when the RSI is high?
A high RSI in the overbought zone (between 70 and 100) indicates strong buying pressure. This might suggest a selling opportunity, but be cautious, as stock prices can continue to rise even after entering the overbought zone. Some traders prefer to wait for additional confirmation signals, like the RSI exiting the overbought zone, before selling.
Maxime holds two master’s degrees from the SKEMA Business School and FFBC: a Master of Management and a Master of International Financial Analysis. As founder and editor-in-chief of NewTrading.fr, he writes daily about financial trading.
Enjoy free trading practice on
ProRealTime Paper Trading Simulator.
