What is the RSI calculation and its formula? The relative strength index is a momentum indicator that shows overbought and oversold levels when trading. 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.
Technical analysis is an important part of successful trading. Knowing how to use the RSI calculation helps keep trades in perspective.
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 can be used to quiet the noise.
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 and 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.
- The 14-day period to calculate the second half of the RSI calculation.
- RSI rises as # of positive closes increases & falls as # of negative closes increases as well.
Momentum Indicator
The RSI, also known as the relative strength index, is a momentum indicator. Investopedia 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 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 cross-check the RSI against other technical indicators.
That will tell you whether or not the current trend is strong or a pullback is imminent. Confirmation is key in trading.
RSI Calculation Math
The RSI calculation is a two-part calculation.
Hence, we are 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 of gains or losses over a look-back period of 14 days. This uses positive values for the average loss.
You need 14 days 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:
Those calculations show us the movement of the market or the stock 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 increases. The opposite is also true. RSI falls as the number of negative closes increases as well.
Then, the second RSI calculation is done to smooth out the price movement. Hence, you see the RSI indicator 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, we typically consider it regarding potential pullbacks or reversals. However, it can also be used to confirm a current strong trend.
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 whether a stock is ready for a pullback or the current trend is strong.
Typically, when you see the RSI in the 70-100 percentile, you expect the stock to come down in price. When the stock is in the 0-30th percentile, you know the price will reverse, usually to the bullish side.
However, it doesn’t always happen right away. This is because sometimes a trend is strong, and the relative strength index confirms it.
Avoiding a Trap
One thing you want to avoid is relying heavily on just one indicator. That can result in getting trapped or faked out.
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.
You can better understand what’s going on when you compare the relative strength index to the MACD, VWAP, and moving averages.
Moving average lines act as an equilibrium for stocks. Therefore, look for a potential pullback if a stock has an overbought or oversold RSI and the price is far from moving averages.
However, if the 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 You
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.
They are formed from the tug of war between buyers and sellers and help calculate the RSI. 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 regarding where support and resistance are mapped 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.
Final Thought on RSI Calculation
The RSI calculation is a technical indicator that maps 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 not 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
