Relative Strength Index (RSI)

The relative strength index (RSI) is a technical analysis indicator that examines the size of
recent price fluctuations to determine if a stock or other asset is overbought or oversold. The
RSI is represented by an oscillator (a line graph that travels between two extremes) with a
range of 0 to 100. J. Welles Wilder Jr. created the indicator and published it in his important
1978 book "New Concepts in Technical Trading Systems."

Values of 70 or higher on the RSI, according to traditional interpretation and usage, signal
that an investment is becoming overbought or overvalued, and may be ready for a trend
reversal or corrective retreat in price. A reading of 30 or less on the RSI suggests that the
market is oversold or undervalued.

The RSI is computed with a two-part calculation that starts with the following formula:

The key components of the RSI are the RS, Average Gain, and Average Loss. The 14 periods
used in this RSI calculation are the default given by Wilder in his book. Positive values, not
negative numbers, are used to express losses.

Simple 14-period averages are used for the first estimates of average gain and average loss:

First Average Gain = Sum of Gains over the past 14 periods / 14

First Average Loss = Sum of Losses over the past 14 periods / 14

The following estimates are based on the previous averages and the present gain loss:

Average Gain = [(previous Average Gain) x 13 + current Gain] / 14

Average Loss = [(previous Average Loss) x 13 + current Loss] / 14
The formula uses the average percentage gain or loss over a look-back period as the average
gain or loss. The average loss is given a positive value in the formula. Periods with price
losses are counted as 0 in average gain calculations, while periods with price increases are
counted as 0 in average losses calculations. The initial RSI value is calculated using 14
periods as typical.

Once there are 14 periods of data available, the second part of the RSI formula can be
calculated. The second step of the calculation smooths the results.

Consider the case where the market has closed higher seven times in the last 14 days, with an
average gain of 1%. The subsequent seven days all ended with a loss of 0.8 percent on
average.
The calculation for the first part of the RSI would look like the following expanded
calculation:

55.55=100−[100/1+(1%14)(0.8%14)]

Using the formulas above, the RSI can be calculated, where the RSI line can then be
plotted beneath an asset’s price chart.

The RSI will climb as the number and magnitude of positive closes rises, while falling
as the number and amount of losses rises. The RSI is only near 100 or 0 in a highly
trending market since the second component of the computation smooths the outcome.

From the below diagram we can understand that the RSI indicator can linger in the
overbought range for extended periods of time while the stock is in an uptrend, as
shown in the chart above. When the stock is in a decline, the indicator may stay in
oversold area for quite some time. For inexperienced analysts, this can be perplexing,
but understanding how to use the signal in the context of the current trend can help to
clarify the situation.
Image by Sabrina Jiang © Investopedia 2021