The Relative Strength Index, or RSI, is an indicator that moves back and forth between 0 and 100, providing insight into the underlying strength or weakness of stock prices. It is used in various capacities, including confirming trends, providing trade signals and foreshadowing reversals. To use the RSI effectively we must understand how it works and its trading applications, as well as its strengths and limitations.
What is the Relative Strength Index (RSI)?
Developed by J. Welles Wilder—who also developed the Average True Range, Average Directional Index and, Parabolic SAR—the RSI is a very popular indicator.
The RSI moves higher when the average gains over a period, typically 14 days, are larger than the average losses. The indicator moves down when the averages losses are greater than average gains. Put another way, if the indicator is at 100, over the last 14 days it was all gains. If the indicator is at zero, all 14 periods were losses.
The indicator is calculated using the following formula, which requires a number of steps:
*RSI = 100 – [100/(1+RS)]
*Where RS = Smoothed Average Gain / Smoothed Average Loss
*Average Gain = Sum of gains over the last 14 periods/14
*Average Loss (expressed as a positive number) = Sum of losses over the last 14 periods/14
To create a smoothed RSI average, similar to a moving average, another step is added:
*Smoothed Average Gain = [(previous Average Gain) x 13 + current Gain]
*Smoothed Average Loss = [(previous Average Loss) x 13 + current Loss]
The indicator is typically used on daily charts with a period of 14, which equates to 14 days. Decrease the number of periods to make the indicator more sensitive to price changes. Increase the periods to make the indicator less sensitive.
Using the indicator on other timeframes also works. A 14-period RSI applied to an hourly chart will base calculations off the last 14 hours.
Figure 1 shows how the RSI looks on a chart, moving with price. All charts created using http://www.StockCharts.com
Trading with the Relative Strength Index (RSI)
The RSI is used in a number ways. Three popular functions are overbought/oversold levels, RSI ranges and divergence.
Via media and analysis it is frequent to hear phrases such as “The stock is overbought” or “WXYZ is oversold.” Often the speaker is referring to the stock’s RSI reading.
When the RSI is above 70 (or 80 is often used as well) it shows a strong run higher in price, which may not be sustainable, and therefore due for a correction.
When the indicator is below 30 (or 20) it shows a strong run lower which may not be sustainable, and the price may be due for a rally.
Unfortunately, it is not as easy as buying when the indicator moves below 30 or selling above 70, some confirmation of a change in direction is needed. Allow the price to cross below 30 and then rally back above it before buying. Let the price cross above 70 and then back below it before selling.
This approach can work well in ranging markets, when the price is swinging back and forth between overbought and oversold levels. As Figure 2 shows the price may not always reach 30 or 70; if the stock doesn’t quite reach the pre-defined levels, alternate levels can be used, such as 35 or 65.
When a buy is triggered a stop is placed below the recent swing low. A sell signal is used to exit long trades or initiate short positions, with a stop above the recent swing high.
During trends, the RSI will usually stay contained within certain readings. During an uptrend it typically bottoms above 30 and frequently reaches 80+. During a downtrend the indicator will typically top out before 70 and frequently reach 20 or below. This can be used to confirm trends, and provide entry signals during a trend.
During an uptrend, buy if the price drops below 35 (or 40) and then rallies back above it. Place a stop loss below the recent low. Sell when the price moves above 70 (or 80) and then drops back below.
One problem with this strategy is that the RSI may not provide an exit signal, in which case, a winning trade may turn into a loser. For such occasions, having a price target or another exit method is needed.
Each stock moves differently, and therefore may have a slightly different range. Adjust levels to suit the individual stocks movement, for example 40 may be the entry point instead of 35.
During a downtrend, short-sell if the price rallies above 65 and then drops back below. Place a stop above the recent high. Cover the short position when the stock drops below 30 (or 20) and rallies back above it.
The RSI is also used to spot divergence. Bearish divergence is when the price is rising, but the RSI falling. It warns the price could soon correct lower since buying momentum is slowing.
Divergence (bullish or bearish) is not a timing signal, as it can last a long time. Rather, divergence helps confirm other signals, and lets traders know when a trend may almost be over.
Bullish divergence is when the price is falling, but the RSI is rising. It warns the price could soon move higher since selling momentum is slowing.
Divergence on major trends warns of an overall change in direction, while divergence on a small scale, as shown on Figures 5 and 6 may only indicate a small correction or short-term change in direction.
Limitations of the RSI
The RSI has several limitations, as all indicators do. Since the indicator is showing momentum, as long as momentum remains strong (up or down) the indicator can stay in overbought or oversold territory for long periods of time. Therefore, price analysis or some other confirmation is still needed for reversals.
The same is true for divergence. While the RSI may be dropping and price rising, that doesn’t mean price will drop soon. The RSI is just showing that the price is moving higher at a slower pace than it was before. Confirmation of a reversal is still needed, such as lower swing highs and lower swing lows in price.
RSI ranges can help confirm trends, but each stock or market will have slightly different levels. One stock may repeatedly move to 38 on pullbacks, while another goes to 33. Therefore, some adjustment is often needed for each stock, since a one-size-fits-all approach may not work.
The Bottom Line
The RSI is popular because it has multiple uses. It is used to find entry exit signals based on overbought/oversold reading and trending ranges, and can help spot or confirm reversals via divergence. Like any technical analysis tool though, the RSI is prone to providing false signals. Price analysis is still need to determine if a trend is present, and then important RSI levels identified for that particular security.