Introduction

The Relative Strength Index, developed in 1978 by J. Wells Wilder, is a momentum oscillator. It computes the change of price moments and their speed. It is a versatile tool to study different asset classes across various timeframes.

How to calculate the Relative Strength Index?

Calculating the Relative Strength Index involves the following six steps:

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Step 1: Choose a Period

Select the period for which you want to compute the RSI. Usually, the RSI is calculated for a period of 14 days. However, you can compute it for a shorter or longer period.

Step 2: Gather Price Data

Collect the closing prices of the asset for the selected period.

Step 3: Calculate Price Changes

Price Gain = Current Closing Price - Previous Closing Price (if it's positive)

Price Loss = Previous Closing Price - Current Closing Price (if it's negative)

Step 4: Calculate the Average Gains & Losses

Average Gain = (Total of gains during the period) / Number of periods

Average Loss = (Total of losses during the period) / Number of periods

Step 5: Calculate the Relative Strength

RS = Average Gain / Average Loss

Step 6: Calculate RSI

RSI = 100 - (100 / (1 + RS))

How to Interpret the Relative Strength Index?

• RSI values typically range from 0 to 100.
• An RSI above 70 is often considered overbought, suggesting that the asset may be overvalued and that a reversal or pullback may be imminent.
• An RSI below 30 is often considered oversold, indicating that the asset may be undervalued and that a reversal to the upside may be near.
• RSI values between 30 and 70 are often seen as neutral and may indicate a trending market.

Using the Relative Strength Index in Trading

• When the RSI crosses above 70, it suggests that the asset is overbought, and a downward correction or reversal may occur. Traders may consider selling or taking profits.
• When the RSI crosses below 30, it suggests that the asset is oversold, and an upward correction or reversal may occur. Traders may consider buying or entering long positions.
• RSI can be used to assess the strength of a trend. If the RSI remains consistently above 70 during an uptrend, it indicates a strong bullish trend. Conversely, if it remains consistently below 30 during a downtrend, it suggests a strong bearish trend.
• RSI can help identify potential support and resistance levels. If the RSI repeatedly respects certain levels (e.g., consistently bounces off 40 or 60), those levels may act as support or resistance to the asset's price.

Conclusion

The basis of the RSI is that the prices tend to move in cycles. Thereby, essentially meaning that overbought and oversold conditions can signal potential trend reversals.

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