Introduction to Relative Strength Index

The RSI was created by Welles Wilder and many trading strategies have been designed around this indicator.  It is intended to chart the current and historical strength or weakness of a stock or market based on the closing prices of a recent trading period. From trading oversold and overbought levels to trend determination via the 50 level, the RSI momentum indicator makes up the backbone of many different types of strategies.

The following are topics of all the articles we will cover in our MasterClass on RSI:

Part 1: Introduction to RSI
Part 2: Overbought-Oversold Strategy
Part 3: Midline Crossover Strategy
Part 4: Fast-Moving RSI
Part 5: RSI in Multiple Time-Frames

In this Part – 1 of our RSI MasterClass, we’ll be giving an in-depth introduction to what RSI is and how to use it. We’ll be discussing the following topics in-depth with descriptions on chart wherever necessary:

  • RSI as a Momentum Oscillator
  • Formula Breakdown and Relative Strength
  • Look-Back Period and its Variations
  • Overbought-Oversold Conditions
  • Risk Management
  • Use Cases of RSI
Video Tutorial

Idea

The RSI is classified as a momentum oscillator, measuring the velocity and magnitude of directional price movements. Momentum is the rate of the rise or fall in price. The RSI computes momentum as the ratio of higher closes to lower closes: stocks which have had stronger positive changes have a higher RSI than stocks which have had stronger negative changes. The RSI is displayed as an oscillator, a line graph that moves between two extremes, and can have a reading from 0 to 100. 

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.

Formula

The relative strength index (RSI) is computed with the following formula:

where RS is the Relative Strength

Relative strength is a ratio of a stock price performance to a market average (index) performance. To calculate the relative strength of a particular stock, divide the percentage change over some time period by the percentage change of a particular index over the same time period. This ‘time period’ is called the look-back period of RSI which is 14 by default which makes the formula look somewhat like this:

The average gain or loss used in the calculation is the average percentage gain or loss during a look-back period. The formula uses a positive value for the average loss.

Default look-back period of 14 means that while calculating the Relative Strength, average gains/losses will be considered from the past 13 days + the current values. The look-back period can be set as a “parameter” in the RSI indicator block on Mudrex. A look-back period greater than 14 would give us a smoother RSI signal which follows the general trend but does not change much by frequent market volatilities. A look-back period smaller than 14 would give us a rough volatile RSI signal which is more reactive to recent price changes.

Candlestick Chart

The RSI will rise as the number and size of positive closes increase, and it will fall as the number and size of losses increase.  RSI will near 100 or 0 in a strongly trending market.

As you can see in the above chart, the RSI indicator can stay in the overbought region for extended periods while the stock is in an uptrend. The indicator may also remain in oversold territory for a long time when the stock is in a downtrend.

Generally speaking, RSI touching the overbought condition is a bearish sign, which means that the prices are likely to fall in the near future and the trader might want to generate a sell signal when that happens. While RSI touching the oversold condition is a bullish sign and can be used to generate a buy signal. The effectiveness of the above however depends on the threshold conditions and look-back period of RSI.

Risk Management

The overbought and oversold conditions are defined by how much risk the chartist is willing to take. The more extreme the conditions are, the lesser the number of trades, the better the chances of a successful prediction. The thresholds are generally set to a safe 70-30 but other popular pairs are 66-33 (risk tolerant) and 80-20 (risk averse). RSI will only cross 80-20 when there’s a strong momentum jump and thus can give us better and safer quality trades than 70-30. Where as in case of 66-33, RSI might oscillate quite frequently in that range so it’s safer to use this pair along with some trend indicator to prevent losses.

Use Cases

There are multiple ways of using the RSI indicator to detect momentum or trend of the market. The following are the most popular implementations of the indicator:

  • Overbought-Oversold Levels: If the RSI is less than 30, it means that the market is oversold, and that the price might eventually increase. Once the reversal is confirmed, a buy trade can be placed. Conversely, if the RSI is more than 70, it means that it’s overbought, and that the price might soon decline. After a confirmation of the reversal, a sell trade can be placed.
Overbought-Oversold Levels
  • Midline Trend: The 50 level is the midline that separates the upper (Bullish) and lower (Bearish) territories. In an uptrend, the RSI is usually above 50, while in a downtrend, it is below 50.
Midline Trend
  • Divergence: A bullish divergence occurs when the RSI creates an oversold reading followed by a higher low that matches correspondingly lower lows in the price. A bearish divergence occurs when the RSI creates an overbought reading followed by a lower high that matches corresponding higher highs on the price.
RSI Divergence
  • Trend Lines: Connect tops and bottoms on the RSI chart itself and trade the trendline break. To draw an RSI uptrend line, connect three or more points on the RSI line as it rises. A down trendline is drawn by connecting three or more points on the RSI line as it falls. The break of an RSI trendline might indicate a potential price continuation or a reversal.
RSI Trend Lines
  • Crossovers: Apply a short 5 period RSI (RSI 5) over the longer (default) 14 period RSI (RSI 14) and watch for crossovers. When the RSI 5 crosses above the RSI 14, it means that recent prices are getting higher and a buy signal can be generated. When the RSI 5 crosses below and becomes lower than the RSI 14, it means that recent prices are declining and a sell signal can be generated.
RSI Crossovers

The Bloomberg trading terminal polled its users and the most used trading indicator was the RSI, the relative strength index. In the next article of our RSI MasterClass we’ll be talking about how to use the overbought and oversold conditions to generate buy/sell signals on Mudrex.

Stay tuned!

Links

A few quick references below: