What Is RSI?
RSI stands for relative strength index, it’s a technical analysis indicator that traders use to gauge momentum and if a stock is either overbought or oversold. The indicator was created by Welles Wilder and introduced to the public in the late 1970s.
How RSI Is Formulated
You can calculate RSI using this formula: RSI=100 {100/(1 + (Average of Upward Price Change/Average of Downward Price Change)}
The indicator measures the speed and change of price movements. That said, it oscillates between 0 and 100.
Now, you don’t necessarily need to know how to calculate RSI yourself, it can be found on most charting packages. That said, it’s more important to understand how to read RSI.
Traditionally, the relative strength index uses a 14 look-back period.
How To Read Relative Strength Index
The relative strength index is considered overbought when it’s above 70 and oversold when it is 30 or below.
Examples:
The chart looks at the SPDR S&P 500 ETF (NYSE: SPY), notice that it peaks as it reaches an RSI above 80, indicating an overbought condition. On the other hand, there were two occasions where the relative strength index hit 30, indicating that the ETF was oversold.
The overbought condition eventually leads to a sell-off. After the oversold reading, the ETF did bounce back. That said, taking a long based on oversold reading would be considered a contrarian strategy since you’re going against the trend.
The highlighted areas are oversold and overbought relative strength index readings. Notice how the United States Oil Fund (NYSE: USO) tends to see its price reverse after these conditions are met.
Divergence Signals Using Relative Strength Index
Sometimes a stock or ETF will make higher highs but RSI may not follow suit or even decline. According to Wilder, he defines that as bearish divergence. A potential spot where the stock price might reverse its direction.
In this chart, shares of Tesla make new highs but fail to make a higher relative strength index. Shares of the stock dropped shortly afterward.
Bottom Line
Relative strength index is a popular technical analysis indicator used to measure speed and change of price movements. Traders use it to spot if a stock is either overbought or oversold. That said, no technical analysis indicator is foolproof. Test it out for yourself and see its of any use to your trading.
