What is the Relative Strength Index?
Key takeaways
Relative Strength Index (RSI) is a momentum indicator that measures the speed and magnitude of price changes.
Generally, RSI is considered overbought when above 70 and oversold when below 30.
RSI divergence and failed swings can also generate trading signals.
Understanding the Relative Strength Index
Relative Strength Index (RSI) was proposed by J. Welles Wilder as a momentum indicator measuring the recent price change magnitude. It can be used to determine whether the price of stocks or other assets is overbought or oversold. The calculation formula is
where RSI equals the average gain of the up n days divided by the average loss of the down n days. According to Welles (1978), the standard time n is 14, but investors can also choose different n values based on different trading instruments and trading strategies.
How to interpret the Relative Strength Index
Overbought and oversold
In market analysis and trading signals, generally speaking, when the RSI is below 30, it is considered oversold and typically seen as a call signal. Conversely, when the RSI is above 70, it is considered overbought, seen as a put signal. Investors can also set the RSI overbought and oversold ranges based on the actual trading variety and strategy. For example, 20 and 80 are commonly used for some volatile and high fluctuation trading varieties.
Divergence
In general, the trend of RSI is similar to price movements, but in some cases, there may be a divergence between RSI and price trends. Divergence is a phenomenon in technical analysis used to describe the temporary opposite movements of some technical indicators that should have moved in the same direction as the symbol's price. When the security price reaches a lower low and the RSI forms a higher low, a call divergence occurs in the RSI.
When a security price reaches a higher high and the RSI forms a lower high, a put divergence in the RSI occurs.
Failed swing
RSI’s failed swing may be a signal of price reversal, completely independent of price and only looking at RSI changes. When the RSI fails to surpass the highs in an uptrend or the lows in a downtrend, a failed swing occurs, considered a put or call signal.
Put failed swing
RSI rose to 70 but quickly fell back below 70.
RSI slightly rose but still below 70.
RSI dropped below the previous low point.
Call failure oscillation
RSI dropped to 30 but quickly rose above 30.
RSI retracted but still above 30.
RSI breaks previous high.
Limitations of RSI
As a momentum indicator, RSI has certain trading reference value. Investors can identify relevant trading opportunities through RSI overbought and oversold conditions. However, it is important to note that RSI may become less accurate when the price trend is strong, so caution should be exercised. In addition, the reliability of a single technical indicator is limited. In practical application, investors who use technical analysis often combine multiple technical indicators to confirm the timing of trades, thereby increasing the probability of successful trades.
