The Relative Strength Index, or RSI, is a widely used technical analysis tool used to measure the momentum of a financial asset. This indicator was developed by J. Welles Wilder, Jr. and introduced to the public in 1978.
The RSI compares the average gains and losses of an asset over a specified time period, typically 14 days. It then presents this information on a scale of 0 to 100, with readings above 70 indicating that an asset is overbought and readings below 30 indicating that an asset is oversold. Traders often use these readings to identify potential buy and sell signals.
How to Calculate RSI
To calculate RSI, one must first calculate the average gains and losses of an asset over the chosen time period. The formula for calculating the average gain is:
Average Gain = [(Previous Average Gain) x (N-1) + Current Gain] / N
Where N is the number of time periods selected, typically 14 days.
The formula for calculating the average loss is:
Average Loss = [(Previous Average Loss) x (N-1) + Current Loss] / N
Where N is the number of time periods selected, typically 14 days.
The RSI calculation is then as follows:
RSI = 100 - (100 / (1 + RS))
Where RS is the average gain divided by the average loss.
Interpreting RSI Readings
As mentioned earlier, RSI readings above 70 indicate that an asset is overbought, while readings below 30 indicate that an asset is oversold. These levels are not, however, definitive buy or sell signals. Traders often use these levels as a guide to help identify potential buy and sell signals.
For example, when an asset is overbought, a trader may consider selling the asset or taking a short position. When an asset is oversold, a trader may consider buying the asset or taking a long position. However, traders should always use additional analysis and tools to confirm their decision, as RSI alone should not be relied on as the sole indicator.
Another way to interpret RSI readings is to look for divergences. A divergence occurs when the price of an asset is moving in one direction, while the RSI is moving in the opposite direction. This can be a signal that a potential trend reversal is on the horizon.
Conclusion
The Relative Strength Index is a widely used technical analysis tool that can help traders identify potential buy and sell signals. However, it should be used in conjunction with other analysis and tools to confirm decisions. It is important to remember that RSI readings are not definitive buy or sell signals and should be used as a guide to help identify potential opportunities. Traders should always exercise caution and use appropriate risk management strategies when making trades.
