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4 Min. Read

Relative Strength Index (RSI): Definition & Calculation Guide

Relative Strength Index (RSI): Definition & Calculation Guide

To make sound investments, understanding the Relative Strength Index can be helpful. Use this guide to calculate it for yourself.

Whether you have just started investing or are a seasoned investor, you may come across the term RSI. RSI or Relative Strength Index is an indicator of momentum. It's one of the technical analysis tools investors use to read financial markets and make a price action.

Here’s What We’ll Cover:

What Is the Relative Strength Index (RSI)?

How Do You Calculate the Relative Strength Index?

What Are The Limitations of RSI?

Key Takeaways

What Is the Relative Strength Index (RSI)?

The Relative Strength Index is a way for investors to tell the price momentum of a stock. Is it generally positive or negative? Which way is the pendulum swinging? How fast are bidders causing the price to swing upwards or downwards? Daily charts measuring RSI can help you spot potential price reversals before they happen.

RSI is on a scale of 0-100. By placing the RSI chart below the price chart, traders can see how the momentum affects the market price. It’s part of the technical analysis involved in smart trading.

How Do You Calculate the Relative Strength Index?

Calculating RSI values is a two-step process:

Step 1

RSI step one =100−[100/ 1+ Average loss / Average gain]

This first formula turns the average gain or loss into a percentage. Most periods use a period of 14 days to calculate the loss or gain of the stock market price.

Step 2

RSI step two =100−[ 100/ 1+ ((Previous Average Loss×13) + Current Loss)) /(Previous Average Gain×13) + Current Gain]

Step 2 takes into account the previous market price at 14 days to where it stands today. This is the way you calculate the change between them

All in all, a simplified formula that combines the two steps would be:

RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]

How to Interpret RSI Values

After calculating the RSI values, you can plot them on a graph. Most traders then match then with the market price graph to see the overall pattern.

There is a rule of thumb among traders for interpreting RSI values. If the RSI is trending over 30%, it’s known as a bullish sign. A bullish divergence is a stock that is being oversold, that subsequently matches the lower lows and higher lows in price.

If it is sliding below the 70% mark it is known as a bearish sign. A bearish divergence is a stock trend that subsequently matches the lower high with the higher highs in price.

Most traders want to see stocks within these two markers. Above 70% could indicate that the stock or security is overbought. Or it could be overvalued. Below 30% is equally telling. It typically shows that a stock is overselling or undervalued.

0% and 100% are rare, but can happen in the market with strong trends.

What Are The Limitations of RSI?

The limitations of RSI all have to do with the trading period. As a momentum indicator, the trend lines are much more reliable in the macro than in the micro. It's difficult to see trend reversals, sell signs or overbought levels accurately in short time periods.

Relying too heavily on RSI indicators to let you know if a stock is trending up or down can lead to false signals.

For example, say a stock appears to have bullish momentum within the trading period you are analysing. But the following week it has a sharp price decline. That would be a false positive.

Likewise, a false negative could show a security trending bearish, then it miraculous trends upwards in price. Potential reversals and directional price movements like these are hard to see.

RSI is also only really suited to markets that are quite volatile. Or “oscillating markets”. This is because it measures momentum. An asset or stock in a more stable market can stay overbought or oversold for a long time. RSI analysis isn’t too helpful in those situations.

Key Takeaways

The Relative Strength Index of any stock or security can help traders like you understand the momentum of an asset. It can then help you make sound trading decisions.

For more investment guides like this one, head to our resource hub!