The Relative Strength Index (RSI) is a momentum oscillator developed by J. Welles Wilder to measure the velocity and magnitude of directional price movements. This is done by comparing upward movements in closing price to downward movements in price over a selected interval. Like the DeMarker indicator the RSI is designed to help determine underlying trend strength and identify over-bought/sold trade conditions. The RSI formula provides a smoothing characteristic which helps overcome distortions seen in other momentum indicators which have been introduced by large price movements at the start of the analysis interval which can cause sudden movements in the indicator even when the current price is little changed.
RSI = 100 – 100/(1+RS) where RS = Average Gain / Average Loss
The very first calculations for average gain and average loss are simple 14 period averages. The default RSI calculation is 14 periods as suggested by Wilder.
- First Average Gain = Sum of Gains over the last 14 periods / 14
- First Average Loss = Sum of Losses over the past 14 periods /14
The second, and subsequent calculations are based on prior averages and the current gain/ loss.
- Average Gain = [(previous Average Gain) * 13 + current Gain] / 14
- Average Loss = [(previous Average Loss) * 13 + current Loss] / 14
Trading with the Relative Strength Index (RSI)
The Default time span for the calculation of the RSI is 14 periods. The overbought and oversold lines are typically drawn at 70 and 30, respectively. Like the DeMarker indicator longer time spans in the calculation period will result in smaller swings in the oscillator and vice versa, therefore traders typically construct narrower overbought and oversold lines for longer time periods. Shorter period RSI’s will display more volatility, making them suitable for analyzing overbought and oversold conditions. Longer period time spans are better suited for constructing trend-lines and analyzing price patterns.
Traders should look to go long when the RSI falls below 30 and rises back above it or where there is a bullish divergence with price where the first trough is below 30. Traders should look to initiate short positions when the RSI rises above 70 and falls back below it or where there is a bearish divergence with price where the first peak is above 70. Failure swings, in overbought or oversold territory signal a weakening trend and probable reversal, they also add additional weight to other signals. A bullish failure swing occurs where a trough in oversold territory precedes a second higher trough (the high of the intervening peak must not reach overbought levels) and the subsequent up-move rises above the intervening peak. A bearish failure swing occurs where a peak in overbought territory precedes a second lower peak (the low of the intervening trough must not reach oversold levels) and the subsequent down-move falls below the intervening trough.
Traders should initiate a long position during an up-trend when the RSI falls below 40 and rises back above it and go short in a downtrend when the RSI rises above 60 and falls back below it. Buy and sell levels may be adjusted higher/lower during strong trends as signals provided by the 70/30 lines can be infrequent (typically with longer period candles) and the trend favours the direction of the trade. Traders may wish to take profit on divergences with price or exit using a trend indicator. Traders should avoid selling/buying at overbought/oversold levels in strongly trending markets as subsequent periods of sideways trading can return the oscillator to more normal levels without any material favourable movement in the direction of the trade. Strong market participation during extreme buying/selling means trending prices often continue after the overbought/oversold levels are first breached. Traders are therefore advised to wait for a loss of momentum in the move with reversals in the RSI back through the oversold/bought bounds and failure swings.