What is the Relative Strength Index, or RSI?
The RSI is a technical analysis procedure implemented by an analyst, J. Welles Wilder, in 1978 and which was actually the subject of a book named ‘New Concept in Technical Trading System’.
Nowadays the Relative Strength Index is one of the most used indicators throughout the world by technical analysts and investors, both individual and institutional.
The function of this indicator is to take into account the dynamics of a given market, or its strength, by comparing the profits and losses made over a given period.
To achieve this, the RSI only takes into account the closing time rates for the underlying asset. It is therefore a limited indicator of which the value oscillates between 0 and 100.
It is important to note that contrary to other indicators of this type, and despite the name ‘Relative Strength’, the RSI does not compare the asset against an index and therefore a market, it uniquely measures the internal strength of an asset. The losses here are registered as an absolute value and not a relative value.
Although it is possible to use different periods for analysing the RSI, it is recommended to limit analysis to periods 5, 9 and 14. Of course, it is best to test various periods to verify which is the most effective.
Calculating the RSI indicator:
As explained above, the RSI uses a comparison of losses and profits registered over a given period. We can therefore say that the calculation formula is as follows:
We note that P corresponds to the average profit and L the average loss.
How to use the RSI indicator when trading?
The interpretation of the RSI aims to provide indications on the speed at which the market is rising or falling. To achieve a good RSI analysis we use the following zones:
- Between 0 and 30, the RSI indicates an oversell zone. You should therefore avoid selling at this time.
- Between 70 and 100, it indicates an overbuy zone. You should therefore avoid buying at this time.
- Between 30 and 70, it does not give any specific information.
We would like to draw your attention to the fact that the RSI, interesting as it may be, should not be used alone for determining a selling or buying opportunity. It is actually essential to combine the information obtained with other types of indicators such as notably the support and resistance levels. By combining the indications obtained through several different indicators we can obtain more reliable sell or buy signals.
Another interesting indicator to use with the Relative Strength Index is that relating to divergences, or differences. This is produced when the rate of an asset is moving in the direction contrary to that of the indicator. These differences are extremely reliable when they are used in an overbuy or oversell zone of the RSI index.