Price movement in the stock market, or any other financial market for that matter, follows patterns that help investors and traders determine which direction trends are headed. That’s the basis of technical analysis, a type of analysis traders use to give them a competitive advantage when they trade. This form of analysis relies on several indicators that make patterns easier to visualize.
One such indicator is the relative strength index (RSI).
However, its name sends the wrong message. The relative strength index doesn’t tell you anything about the relative strength of an asset. For example, if the biotech sector outperforms the S&P 500, it has relative strength; if it underperforms the index, it has relative weakness.
Instead, the RSI is a singular-focused momentum oscillator that doesn’t make comparisons between one asset, sector, or market to another. Read on to find out what it does.
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What Is the Relative Strength Index (RSI)?
The RSI is a technical indicator developed by J. Welles Wilder Jr. and presented to the trading community in his 1978 book “New Concepts in Technical Trading Systems. ”It’s a momentum indicator that tells you if recent price movements have pushed an asset near or into overbought or oversold conditions.
The RSI oscillates between two extreme values — 0 and 100. Traders often interpret readings differently, but traditionally an asset or market is considered overbought when its RSI value is 70 or above and oversold when its value is 30 or below. Some traders use 80 and 20, respectively, to reduce the occurrence of false signals.
These RSI values act as trading signals, indicating what could be the best times to enter or exit a position.
RSI crossovers indicate that trend reversals may be on the horizon. When the RSI crosses over 30, it’s a bullish crossover, which tells you an uptrend may be ahead. When it crosses below 70, it’s a bearish crossover that tells you the asset or market may be headed into a downtrend.
Calculating RSI
The RSI is calculated using average gains and average losses over a period of time. In most cases, that time frame spans 14 periods, with periods being days, weeks, or months. To determine average gains and losses investors, analyze the closing prices of the asset or market for each period. They then take averages of all gains and all losses separately.
Analysts use a second calculation to smooth the results by taking averages of the data from the first calculation. The results of the second calculation are plotted on a chart so traders can easily visualize patterns in the oscillator’s movements.
The good news is that you won’t ever have to do any of the calculations associated with the RSI unless you want to. There are multiple websites that offer free RSI charts. One popular option is Yahoo! Finance or Investing.com. There’s also a strong chance that your broker or trading platform makes RSI data available for free.
RSI Example
Take a look at Apple’s price chart, courtesy of Investing.com, below.
The RSI indicator is plotted in purple on the mini-chart below the primary stock chart. The overbought level line (I set this one to 80) is the dotted line at the top and the oversold level line (I set this one to 20) is the dotted line at the bottom. Since this is a one-day chart, the RSI is based on data over the past 14 days. If the chart were a one-week chart, the RSI would be based on a period of 14 weeks.
Notice that for the most part, the RSI stays below overbought territory and above oversold territory. However, when the RSI nears either of these key points, a trend reversal usually follows.
RSI Divergence & Convergence
Traders often use the terms convergence and divergence. These terms tell you how two pieces of data relate to each other. In the case of RSI divergence and convergence, the two pieces of data traders pay attention to are the RSI values and stock prices.
RSI Divergence
In finance, a divergence happens when two pieces of data move in opposite directions. An RSI divergence can be bearish or bullish.
A bearish divergence occurs when the RSI of an asset is trending down, forming a series of lower lows, and the stock’s price is moving up, forming a series of higher highs. This pattern usually forms toward the end of a bull market and tells traders that a strong reversal and resulting downtrend are likely.
On the other hand, an RSI divergence can also be bullish. This happens when the RSI is trending up, forming a series of higher lows, and the asset is trending down, forming a series of lower highs. This indicates that the downtrend in the asset is nearing its end and a bullish reversal is on the horizon.
RSI Convergence
In finance, a convergence occurs when two pieces of data agree with one another. When the stock price and the RSI are moving upward together, forming a series of higher highs, a bullish convergence confirms the bullish trend. When the asset’s price is moving down in conjunction with a falling RSI reading, a bearish convergence is taking place, confirming the downtrend.
What the RSI Indicates
The RSI indicator is a momentum oscillator. This means it indicates the veracity of price changes in the market. Traders use the RSI for a few things:
- Confirm Trends. The RSI is commonly used to confirm trends. When RSI data converges with price data, the trend is confirmed and will likely continue. If the two datasets don’t mimic each other, the trend is weak and a reversal is likely.
- Find Long Entries and Short Exits. Traders often use RSI data to find entries. There are two ways to do so. The first option is to look for a bullish divergence. This is a strong pattern that tells you upward movement is likely ahead. The other option is to enter a position or exit short positions when the RSI enters oversold territory.
- Find Long Exits and Short Entries. You can use bearish divergences as sell signals on long positions and entry signals on short positions. Moreover, when the RSI enters overbought territory, downward price changes are likely signaling long exits and short entries.
You can also use RSI data to determine if an entire sector or market is experiencing a strong trend or is likely to reverse soon.
How to Use the RSI Indicator
The RSI indicator is simple to use thanks to the various websites that plot the data on a chart below the stock price. Follow the steps below to get started.
Note. These steps assume you’re using Yahoo! Finance as your RSI data source. Although they may be similar to other providers, you may have to take more or fewer steps to access RSI data on different platforms.
1. Add the RSI to the Chart
First use the search function on Yahoo! Finance to find the ticker symbol of the stock you want to analyze. Then click the “Indicators” link at the top of the chart and choose the RSI indicator.
You can either use Yahoo! Finance’s traditional settings or customize the RSI to fit your needs. If you use the traditional settings, the data is based on the following:
- Periods: 14
- Overbought Value: 70
- Oversold Value: 30
Once you’re happy with these values, click Save and the RSI chart will be displayed beneath the stock price chart.
2. Look at the Current RSI Value
If the RSI is above 70, the stock is overbought and could be headed for a bearish reversal. If the reading is below 30, the stock is oversold and could be headed for a bullish reversal.
3. Compare the RSI to the Price Data
See if the RSI data converges with the price data. If so, the trend is confirmed and likely to maintain its direction. If the stock is trending up and likely to continue, it might be a good time to buy. The opposite is true if you confirm a downtrend.
If instead you notice a divergence between the price data and the RSI readings, a reversal may be on the way.
Determine whether the divergence is a bullish or bearish one. If the price is producing higher highs and the RSI is producing lower lows, the divergence is bullish. If the price of the asset is climbing but the RSI is producing lower highs, it’s a bearish signal. If you notice a bearish divergence, a short position may be in order, and a bullish divergence means it might be time to go long.
4. Confirm the Data Before Acting On It
Few traders find success only using one technical indicator. False positives are a common occurrence with most, and the RSI is no different. Use moving averages, trend lines, and other oscillators to confirm any trend or potential reversal the RSI brings to your attention before making your trade.
Limitations of the RSI
The RSI compares average gains and average losses in an attempt to determine the momentum of price movement in the market. It’s based on the concept that history repeats itself, which isn’t always the case.
Like any technical indicator, the RSI can generate false signals, resulting in bad trades.
For example, you may see a bullish crossover in Apple’s RSI as it breaks over the 30 level, but the trend may continue downward.
Although divergences are more accurate signals than crossovers, they can also result in false signals.
That’s why it’s crucial that you confirm any signals you get from any technical indicator with two or three others before acting on the signal.
Relative Strength Index FAQs
The relative strength index is a rather complex topic that’s known to inspire questions. Some of the most common questions are answered below.
What’s the Difference Between RSI & MACD?
Both the RSI and the moving average convergence divergence (MACD) are momentum oscillators. That means they both help you determine the momentum of a trend and spot potential reversals. The RSI does so by comparing average highs to average lows. The MACD achieves this goal by comparing the 26-period exponential moving average (EMA) to the 12-period EMA.
Because both of these tools are designed to tell you the same thing but do so using different data, they are the perfect pair. You can use the RSI to confirm a finding from the MACD and vice versa.
What Is an RSI Buy Signal?
There are two common buy signals produced by the RSI. The first is the oversold signal, which happens when an asset’s RSI drops below 30. This signal tells you the stock might be undervalued and poised for a rebound.
The second signal is a bullish divergence. This RSI buy signal tells you that a recent downturn may be running out of steam and a bullish trend may be around the corner.
What Makes an RSI Go Up or Down?
The RSI goes up when average gains are higher than average lows and goes down when the opposite is true.
What Is a Good Relative Strength Index?
A good relative strength index depends on how you’re using the data. For example, an exorbitantly low RSI reading suggests a stock is oversold and poised for a rebound, making it a great setup for a long position, but bad for short-sellers.
The important thing is to consider your trading strategy and the moves you’re interested in making, and interpret the signals the RSI gives you based on what they mean to your trading process.
Final Word
The introduction of the RSI has changed the way many trade in financial markets. The data is used by countless professional traders and will likely continue to be used for the foreseeable future.
Although the RSI is great, it’s not perfect.
False signals are a common occurrence. When you’re researching and analyzing opportunities, it’s important to confirm the results of the RSI with another indicator before you make a move.