Relative Strength Index (RSI) is one of the most effective and reliable oscillator indices and market tools for the technical analysis and momentum assessment of the stocks and in fact, the financial market.
When technical analyst J. Welles Wilder Jr., in his 1978 book New Concepts in Technical Trading Systems, introduced a momentum indicator, little did he know the impacts this concept will have on the forex and stock trading market.
As a major player in stock trading, you need to understand a stock or market’s performance to enjoy successful trading in the market. It can also help to know the current and historical strength or weakness of a stock before buying or selling it during a trading period.
The RSI gives stock investors an edge on the market by measuring a stock’s potentials and the volume of its price movement up or down the price ratio. However, the RSI indicator is not applicable in all markets and can be confusing for newbies.
Here’s all you need to know about the relative strength index (RSI) and its application in the financial market.
What is RSI?
In simple terms, RSI stands for Relative Strength Index. It is a momentum oscillator or a technical indicator that measures the magnitude of price movement and analyses the financial market.
The RSI as a momentum oscillator measures a given stock’s recent and historical price performance based on its gains (strength) and loss (weakness) on a trading period’s closing prices.
Stock investors use the RSI to deduce the rate of the rise or fall of a total stock price in determining whether the stock is overbought or oversold. Although the RSI is commonly associated with stocks, it equally examines other assets’ performance, including Options, Currencies, Bonds, Currencies, Commodities, etc.
Relative Strength Index, among other things, help investors to understand the bullish (buying or Overbought trend) and bearish (selling or Oversold trend) price momentum of assets.
How Does the Relative Strength Index Work?
The Relative Strength Index is displayed as an oscillator. An oscillator in financial and stock market terminology is a technical analysis indicator measuring stock performance between two extremely low and high purchase points. Common examples of oscillators include RSI, MACD, CCI, ROC, and MFI.
The RSI oscillates on a scale of zero (0) to hundred (100) and is measured on a 14-days timeframe. The most popular trading ranges occur between 70 and 30. High trading and low trading levels are marked by 70 and 30, respectively. RSI is considered overbought when it is above 70 and Oversold when the RSI is below 30.
In simple interpretation, when the oscillator of a given asset (such as a Stock) slides upward towards 100 (above 70), the reading indicates that the stock is in an Overbought position, which implies a possible price weakening. This bullish market trend allows investors to sell.
Similarly, an asset is Oversold if the RSI slides towards zero (below 30). This is a bearish market trend and likely rise in price. With the RSI, investors can identify a good buying opportunity for a declining stock because it’s believed that the security/stock will reverse its course and gain momentum.
The RSI Formula and Calculation
Investors calculate the Relative Strength Index of security using a simple formula:
RSI = 100 – 100/1+RS
(RS = Average Gain/Average Loss)
If the average gain is greater than the average loss, the RSI will rise, giving us a bullish market trend. If the average loss is greater than the average gain on a given stock, the RSI indicator will fall – bearish market trend.
Relative Strength Index (RSI) momentum oscillator can be a great analytical tool for your investment and stock trading in the financial market. Although the RSI has an ideal application for stock trading, it can be suitable for other securities, including currency, bonds, commodities, and more.