The RSI indicator – the relative strength index, detailed RSI guide
Shares fall and rise in value, trends come and go again. Those who want to hold their own in the financial world and protect their bonds and securities in the long term rely on strategies that have been promising great success for decades. Have you heard of the RSI indicator? Maybe you know the Momentum indicator and are certainly familiar with phrases from the financial world (e.g. “buy low and sell high”), but do you really use the secrets of market developments? If you too are looking for the right strategy to better understand and measure equity developments, you have come to the right place. This article shows you what the RSI indicator was created for, explains the advantages and disadvantages and the RSI formula. The RSI indicator has never been easier to use.
What is the RSI indicator?
What is the definition?
The RSI, the Relative Strength Index (Relative Strength Index), is an oscillating indicator of technical analysis that compares the upward or downward trend of an underlying asset over specific periods of time (typically 14 days) to make predictions about potential developments. Accordingly, the RSI indicator is based on the momentum strategy. It is presented using a line chart on a scale of 1 – 100. The result indicates whether a share or bond overbought (in upward trend) or oversold (in a downward trend). In this sense, the RSI follows the classic strategies of the financial stock exchange: buy cheap and sell dear to make a profit. The RSI was invented in 1978 by J. Welles Wilders Jr. in his publication New Concepts of Technical Trading Systems. As the momentum strategy had already become unpopular by then, Welles Wilde’s publication was seen as the Holy Grail of finance. He defined the new understanding of securities trading.
What does the RSI tell you?
Trading on the stock exchange is not without risks, but the understanding of market developments has changed considerably internationally in recent decades. The RSI is a helpful tool to illustrate these developments. If you calculate the RSI, you can make forecasts about the actual trend of the market. In general, values of the RSI calculation above 70 are called overbought while results below 30 (or 40, depending on the market) are treated as oversold apply.
- Overbought: Line over 70 (bullish trend)
- Oversold: Line under 30 – 40 (bearish trend)
The terms overbought and oversold are seen as warning signals for investors. They indicate that a change in the market is imminent and can therefore avoid losses or make profits. This sharp jump from traps to rises and vice versa is seen as a reversal or Reversion is designated. An oversold market means that the underlying asset has risen too much or too fast, for example because many investors have bought bonds or shares at the same time, while the oversold market describes exactly the opposite: Too many securities have been sold and the underlying asset has collapsed as a result. The scale can change depending on the market or user. For example, the Connors Scale (see Connors RSI chapter) uses the values 5 (oversold) to 95 (overbought), while the RSI expert, John Hayden, places the scale between 33.3 (oversold) and 66.6 (overbought). However, the RSI indicator can also show other developments such as the underlying. In the chart below you can see the trend of the RSI indicator and the actual underlying value of a stock. The term Divergence is used for changes that are not confirmed by the underlying asset. In concrete terms, this means that the RSI can be significantly higher (or lower) than the underlying asset, thus recording a divergence. If the RSI is higher than the underlying asset, this is called positive divergence (see chart). The opposite, a higher market performance of the underlying asset, indicates a negative divergence.
The RSI compared to other strategies
The momentum strategy and the RSI indicator
The RSI indicator is based on the doctrine of the momentum strategy, which aims to identify profitable and risky stocks or bonds. If a market has lost momentum and is falling, shares are sold to avoid losses. The momentum strategy originated about ten years before the idea of the RSI indicator and is strongly based on the idea of Richard Driehaus, who is therefore often called the “father of the momentum strategy”. He believed that shares with a high value should be bought and sold again with even higher values (“buying high and selling higher”). In order to describe developments, the idea of momentum from physics is used. This explains how momentum is built up when a financial product moves into a rising or falling position. Imagine a parabola at whose vertex the opposite development begins – rising becomes falling and vice versa. Momentum is helpful for the financial industry when it is used to expose particularly lucrative or risky stocks. If your next thought now is that stock developments are difficult to control and are developing arbitrarily, you are not alone. Not for nothing is there the famous quote from Isaac Newton (1871-1914): “I can calculate the orbit of the stars in centimetres and seconds, but I cannot calculate where a crazy crowd can drive a stock market price”
However, the momentum strategy says that it can do exactly the opposite: It wants to make forecasts about random developments. Whereby the „random” is very vaguely defined. Based on studies, it is known today that shares actually develop in a trend pattern. Stocks that have fallen or risen sharply in value in the past will continue to do so in the future. The reason for this is that influential factors rarely change and similar market developments can still be observed. The Momentum Indicator therefore has two main functions: On the one hand, it is intended to examine the actual state of the trends, while on the other hand, the vehemence of the price development is observed.
The following formula is used for this purpose: Momentum = current price – price before n days You use the value of the current rate and subtract the rate before n days. By using the formula you create a comparison of the current rate with one of the past. If the value is positive, the share price increases. If it is negative, the share value is falling. Of course, shares do not fall permanently or just rise – developments are reminiscent of a pendulum that can make short and stagnant jumps. The momentum strategy tries to find the point of reversal by means of divergence analyses. These determine when the market will regain momentum in order to become profitable again. These analyses are not based on any scale and therefore differ significantly from the idea of the RSI indicator. Instead, the momentum indicator uses values calculated with the corresponding stock value. As a result, the momentum strategy is often seen as an outdated system that has been boosted by the RSI indicator.
MACD and the RSI indicator
The MACD and RSI indicators are oscillators (oscillating systems), which is why they are often compared. Both try to measure developments, oscillations of the market, but do so in different ways. MACD is an acronym for Moving Average Convergence/Divergence and, like the RSI, refers to aspects of divergence analysis. Compared to the RSI indicator, the MACD uses the divergence of two exponentially smoothed averages (EMAs, Exponential Moving Average). The periods to be compared are traditionally set at 12 and 26 days. The divergence is calculated by subtracting the 26-day period from the 12-day period. The result can be seen on the so-called MACD line. In order to understand indicators for selling and buying, another line is traditionally inserted based on 9 days. As soon as the MACD line crosses the 9-day forecast, this is an indication to buy, while falling below the 9-day forecast is seen as an indication to sell. Due to the differences in the calculation of the two indicators, there may be differences in the trend forecasts. The RSI may indicate an overbought trend, while the MACD may indicate further selling. Therefore, the question often arises as to which indicator is better than the other. The answer depends on your personal preferences.
Stochastic analysis and the RSI
The Stochastic Analysis, or Stochastic Oscillator (stochastic oscillator), is one of the oscillators of technical analysis, as are the MACD and RSI. The idea is that the closing price will always follow a similar trend as the current one. It uses aspects of probability theory to make statements about the future. This form of oscillator was created by George Lane and uses two concepts: If shares are in an upward trend, the closing price is also to be located in the heights of the price. On the contrary, a downtrend closes with its lowest values. Like the RSI, the Stochastic Analysis is presented on a scale from 0 to 100. The market is considered overbought when the line shoots above 80 and oversold when it falls below 20. Next to this general line, a 3-day average is shown to better understand the momentum of the market.
The RSI formula – calculation and explanation
The RSI indicator is traditionally calculated for a period of 14 days, but can be applied to any period (e.g. days, hours and so on). Welles Wilder himself is said to have preferred the 14-day period because he knew it well. If you prefer to rely on a different period, this is an equally acceptable strategy. It should be noted that shorter periods may be less meaningful than longer ones. The formula calculates the RSI indicator based on the average of the ups and downs in a given time frame: RSI=100-(100/(1+RS)) The results scale ranges from 1 – 100, while results over 70 indicate an overbought trend (strong uptrend that is about to fall) and results over 30 indicate an oversold trend (strong downtrend that is now expected to grow). To calculate the RSI, follow two steps. First, you calculate the RSI for a desired time period before you compare the newly calculated value with that of a new time period in the second step.
Step 1: How is the RSI calculated?
The RSI formula is used in several variations. However, all formulas follow the same pattern: you try to compare the average of the upward and downward trend. The most popular formula is therefore the following: RSI=100-(100/(1+RS))
The RS, the Relative strengthis calculated by taking the average of the upward price of n-Days by the average of the downward rate on n-Days is divided.
RS= AverageUpward price / AverageDownward price If you want to observe the upward price of the market over a period of 10 days, proceed as follows: You note the growth of the market, e.g. notice that on three days of the uptrend the market shows growth of 1.2%, 2.6% and 3.4%. The average growth is 2.4% if you divide these three figures by the total number of days.
Average upward rate =(1.2%+2.6%+3.4%)/3=2.4% For the downward rate, you have quoted the values 0.1%, 0.2%, 0.2%, 0.4%, 5%, 10% and 5.1% on 7 days, which gives a value of 3% for the downward rate: Average down rate =(0,1%+0,2%+0,2%+0,4%+5%+10%+5,1%)/7=3%
The value of the RS is now obtained by dividing the upward rate by the downward rate:
If you insert the Relative Strength value in the original formula of the RSI indicator, the final value is 44.5 % (rounded).
This gives you an indication of the RSI.
Using the RSI scale, you can see that the share value has fallen sharply and that an upward swing is expected after this longer period of decline. You have calculated the RSI in this example for a period of 10 days, but have not yet made a comparison with previous market developments. John Hayden comes in his book RSI: The Complete Guide after years of experience with the RSI indicator, the decision was made that the value 50 is only calculated if the value of the upward trend corresponds to the value of the downward trend in a ratio of 1:1. Hayden points out that logarithmic movements can be seen in his calculations. Furthermore, Hayden notes that 2:1 developments result in a 16.67 point change and a 3:1 to 8.33 point difference. To drive the line over a value of 80, it requires a ratio of 4:1, an upward and downward development four times as large. According to Hayden, all values below 50 show an average gain and below 50 average losses.
Step 2: Comparison calculation (h3)
As already mentioned, the forecast for a period of 10 days is not meaningful enough. Imagine you want to buy a share, but only look at the development of the last two weeks. A game of chance that 80% of traders do not win. To get a better overview, investors therefore rely on comparing several periods in order to better understand the market development of a share. The basic calculation of the RSI does not change in this second step. Instead, you calculate the RS in relation to the new time frame you have chosen: RS=Previous average upward pricen−1+current average upward trendPrevious average downtrendn−1+current average downtrend This calculation may seem complicated, but it is easy to explain. You are trying to compare the average of the previous and the current development. The variable n still refers to your number of days. Therefore, if you want to observe a further 10 days, proceed in a similar way to the first invoice. You calculate the new average of the up and down rates and insert your previously calculated averages.
For example, if you observe an average upward rate of 4.7% and a downward rate of 2%, insert these new values into the formula as follows
You will often find this formula with the number 13. The number 13 can be explained by the fact that the RSI is usually calculated for 14 days.
The RSI has risen by about 3% in the comparative calculation, but is still in an oversold trend. If you apply the RSI calculation to further periods, you will find either a consistent upward or downward trend. In either case, traders would now consider buying stocks as they can be bought cheaply and sold more expensively.
Variations of the RSI indicator
Due to the popularity of the RSI indicator, traders and finance professionals have applied their own knowledge to the strategy. Thus, the RSI indicator has been adjusted and tightened several times. The two best known variations are based on Cutler and Connor, although Connors RSI is definitely the more popular RSI as it is still in use.
Cutler’s RSI variant is based on a smoothed average, as Cutler had found when using Wilders RSI that Wilders formula is dependent on the starting point. Cutler called this discovery “Data Length Dependency”. The advantage of Cutler’s indicator is that results are not dependent on data length. Instead, consistent results are presented.
Connors RSI, developed by Larry Connors, is also a variation of Wilders’ RSI indicator and is based on three main elements with the aim of quantifying momentum in prices. It is based on trend analysis, specifically:
- the RSI indicator (typically based on 3 days)
- the UpDown LengthThese are 2 periods in which the number of consecutive upward and downward movements is noted.
- the Rate of Change (ROC): ROC refers to the rate at which a variable changes in a period (represented as the ratio of two changing variables). ROC is a percentage of the changes in a given period.
The Connors RSI has become increasingly popular for crypto currencies, especially in recent years. While the traditional RSI indicator places the overbought and oversold market between 30 and 70, the Connors RSI goes as far as oscillating between 5 and 95. This suppresses false trading signals and creates more opportunities.
How can you use the RSI results to your advantage?
Since the RSI indicator is one of the oscillators, it is used to Signals for market development. The RSI shows you when and how you can take advantage of trends to make profit and avoid losses. Masonson describes in his book Buy–DON’t Holdhow the human desire to make big money influences our decisions. As a result, many traders look for cheaper stocks to avoid big losses, but forget that many others follow the same strategy. Everyone wants cheap shares to suddenly make millions on the rise, but only a fraction of traders actually make a profit. But what are reliable strategies? How can you really take advantage of the RSI? Here you can learn about trading strategies that have emerged from years of trading experience.
The RSI indicator and divergence analysis
As mentioned above, the RSI can show divergences that you would otherwise not notice. This is known as a positive divergenceif the RSI is higher than the underlying asset (bear market), while the opposite is true for a higher underlying asset and a lower RSI, negative divergence (or bull market). Trading based on divergences is a traditional strategy of the financial world. You can assume that a negative divergence indicates an upward trend, as the bull market is seen as an ebbing of the rate of fall. The trend has therefore reached its lowest point and is now inevitably on the verge of rising. If instead you experience a positive divergence, you can expect an imminent fall, as the strength of growth diminishes. Since a fall or rise in the underlying asset always happens mustdivergences are gladly consulted by investors. However, remember that divergences often persist longer than other indicators. It is therefore advisable to compare divergence analyses with other strategies before you make a final decision.
Buy low, sell high
There are only two rules for buying cheap and selling dear: 1. if the RSI indicator falls below 30, it is time to invest money. 2. If the RSI rises above 70, you can sell your shares again to avoid potential losses. The “buy low, sell high” strategy is based on well-known knowledge of the financial world and applies this to the RSI. If the RSI falls, this indicates that other investors are following the same pattern and that a major collapse is imminent. Of course, this does not always have to be the case, but the impulse behaviour of people plays a major role. Before more losses can be recorded, people sell cheaper. If you want to use this strategy, it is advisable to consult other strategies. Those who can keep a cool head avoid impulsive behaviour.
Another strategy is the use of so-called market breakouts. One speaks of a breakout when the price of a stock or bond moves above a resistance area or below a support area. A breakout indicates that the price is now in a trend to breakout.
- Resistance areaor resistance level, describes the price that arises when a share encounters a barrier in an upward trend because more is now being sold.
- Support AreasSupport Levels are created by buyers buying more in the market, thereby creating a loss barrier and thus avoiding greater losses.
If you see a breakout in an uptrend, you stay with the buy. However, if you notice a breakout, if the price is in a downtrend, you sell. Breakouts can be used in two ways. Either you compare past developments with current trends or you choose fixed breakout levels that give you programmed signals. In both cases, a shorter RSI period (for example 7 days) is recommended, while you should set your signals from 30 to 20 and 70 to 80. This increases the scope for detecting breakouts. This strategy does not work in every market and is therefore only suitable for experienced traders. Breakouts are therefore often used on the stock market, but are less frequently used when trading commodities. It is best to play with your market until you find the right settings for your example. What works in one market doesn’t have to work in another for a long time.
The advantages of the RSI indicator
The clear advantage of the RSI indicator is that it allows you to monitor a market that is difficult to understand measurable to do. Stocks fall and rise, but you don’t need a computer or complicated programs to understand developments when you consult the RSI. The RSI is easy to calculate and simply to understand. Furthermore, the RSI indicator can show you investment opportunities that you would not have otherwise noticed. Most markets today use scales to show trends and the RSI has the distinct advantage, Reversals to be recognised. Due to the evaluations you can react faster than others and guarantee your profit. Finally, the RSI easily accessible and is available on many platforms so that you always have an overview. If you still need help in finding suitable platforms, our comparison available.
The disadvantages of the RSI indicator
Due to its calculation periods, the RSI can hardly be used for Trend Markets which are developing faster than the average. The result is problematic divergences that do not authentically represent market developments. An overbought or oversold signal does not always mean that the market will make a U-turn. You rely on the analysis of data that Impulse behaviour of people is not taken into consideration. Longer periods of past market developments do not make the RSI indicator more accurate. The Accuracy is not influenced by the fact that a lot of data has been collected and compared. Future developments do not have to be based on trends that you noticed several weeks ago, for example. In order to get precise results, you therefore need to carry out permanent analyses. Although the RSI indicator is easy to understand and calculate, it still takes time to apply the strategy. If you read signals incorrectly, you can quickly end up in the red. The RSI can be a high learning curve have.
Where can you check the RSI indicator?
The RSI indicator can be found on most stock market websites that display data in pictures. Examples are TradingView (German & English), StockCharts (English), Thinkorswim (English) or Power E*TRADE (English and US focused). Before you decide on a platform, you should use several at the same time to get a feeling for your most suitable platform. The better you know the market, the better your experience will be.
The RSI, the relative strength index, offers you the opportunity to measure and understand market developments. With the help of signals you can buy stocks cheaply and sell them more expensively, thus minimising your losses. The three most common strategies are based on traditional trading ideals: buy low, sell high; breakouts and divergence analysis. If you also want to use RSI for your trading strategies, it is advisable to gain experience via platforms before you decide to buy or sell. It is important that you keep a cool head as usual, because in the end you can only influence your own behaviour, not that of others. Bernard Mannes Baruch, the US financier, said during his lifetime “never follow the crowd”. If you follow this quote, you can consult the RSI with composure.