What is rsi calculation and it’s formula? Relative strength index is a momentum indicator when trading that shows overbought and oversold levels. When stocks become overextended they are like rubber bands that naturally want to pull back to equilibrium levels. Pay attention when a stock becomes overextended because a pullback or extreme move in the stock may be upcoming.
Table of Contents
What Is RSI (Relative Strength Index) Calculation?
- RSI calculation aka relative strength index is an oscillating indicator that is displayed as a line
- It moves between two extremes; overbought and oversold
- The bullish and bearish price movements are plotted against a stock’s price
- Compares bullish and bearish price movements and maps them out as an oscillator
- The calculated range of the RSI is 0-100
- Oversold levels are between 0 and 30. Overbought areas are between 70-100
- Average gain or loss is the average % gains or losses over a look back period of 14 days
- Uses positive values for the average loss
- 14 day period to calculate the second half of the RSI calculation
- RSI rises as # of positive closes increase & falls as # of negative closes increase as well
Technical analysis is an important part of successful trading. Knowing how to use the RSI calculation helps keep trades in perspective.
In fact, day traders are hunters of volatility and the relative strength index shows momentum. The stock market is a tug of war between the bulls and the bears. As a result, technical indicators are tools that can be used to quiet the noise.
Momentum Indicator
The RSI also known as the relative strength index is a momentum indicator. According to Investopedia it measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset.
The RSI calculation was was developed in 1978 by J. Welles Wilder. It was first introduced in his book New Concepts in Technical Trading Systems. The relative strength index gives you clues as to the strength of a trend or if a pullback or reversal is about to occur. Usually you want to crosscheck the RSI against other technical indicators.
That’s going to tell you whether or not the current trend is in fact strong or a pullback is imminent. Conformation is key in trading.
The Math
The RSI calculation is actually a two part calculation. The Bullish Bears is a trading service that likes to research not only what an indicator does but the psychology behind it.
Hence delving into the math that makes up the RSI calculation. If you’re a technical person, sometimes knowing how things work can make you better understand what’s happening.
Let’s take a look at step one of the RSI calculation:
The average gain or loss is the average percentage gains or losses over a look back period of 14 days. This uses positive values for the average loss.
In fact, you need a 14 day period to calculate the second half of the RSI calculation. The second step is what smooths out the noise. The second RSI calculation looks like this:
What those calculations show us is the movement of the market or the stock that you’re looking at. The first RSI calculation shows the number and size of price increases or decreases.
The RSI rises as the number of positive closes increase. The opposite is also true. RSI falls as the number of negative closes increase as well.
Then the second RSI calculation is done in order to smooth out the price movement. Hence the RSI indicator you see on your charts. It only becomes overbought or oversold in trending markets.
What Does RSI Calculation Tell You?
When we think of the RSI calculation, typically we think of it in regards to potential pullbacks or reversals. However, it can also be used to confirm a strong trend currently in place.
If you watch our watch list videos, you’ll notice how closely we pay attention to RSI when looking at potential plays. That’s because we want to determine if a stock is ready for a pullback or if the trend is currently strong.
Typically when you see the RSI in the 70-100 percentile, you expect the stock to come down in price. In fact, when the stock is in the 0-30 percentile, you know price is going to reverse; usually to the bullish side.
However, it doesn’t always happen right away. The reason for this is sometimes a trend is strong and the relative strength index is confirming that.
Avoid a Trap Get Confirmation
One thing you want to avoid is relying heavily on just one indicator. That can result in getting trapped or faked out. Hence the need to learn stock trading.
The need to look at more than one indicator for confirmation is key. Many technical indicators are lagging indicators. As a result, they can be a little behind on moves.
When you look at the relative strength index in comparison to the MACD, VWAP and/or moving averages, you can get a better picture of what’s going on.
Moving average lines act as equilibrium to stocks. Therefore, if a stock has an overbought or oversold RSI and price is far away from moving averages, then look for a potential pullback.
However, if price is riding the moving average lines and the relative strength index is still overbought or oversold, you could be looking at trend confirmation.
What the Patterns Tell
Not only should you use technical analysis to trade but candlesticks and patterns are just as important; if not more so. Candlesticks are the foundation of trading. Take our day trading course.
They are formed from the tug of war between buyers and sellers as well as helping to make the RSI calculation. As a result, you can see the emotions of traders along with support and resistance.
Support and resistance play a huge role in trading. As a result, you can determine the relative strength index calculation in regards to where support and resistance map out.
Technical analysis, candlesticks and patterns all work hand in hand to give you a clear picture of potential moves. However nothing is 100% certain. Take our online trading courses to learn more about implementing these trading tools into your strategy.
The Bottom Line
The RSI calculation is a technical indicator used to map out overbought and oversold areas. This can result in a pullback, reversal or trend confirmation.This indicator works best within a strong trend.
As a result, compare what the relative strength index is telling you to other indicators and candlestick patterns. No indicator is perfect and should be relied on by itself.
Frequently Asked Questions
- The best rsi setting differs based on trading strategy
- The default setting is 14 periods and is most commonly used
- Some traders like to use the 10 period for shorter overbought/oversold levels
- You should look to buy when RSI is in the oversold area anywhere below 30
- When RSI is between 70-100 that is a potential sell signal
- Relative strength index isn't a buy or sell signal, it's used more as a guide
- Candlesticks are much better buy and sell signals than RSI
