What is Relative Strength Index (RSI)?
The Relative Strength Index (RSI) is a tool that, based on an asset’s recent price changes, helps investors predict whether the price may go up or down in the future.
Investors don’t have a crystal ball, but they don’t have to rely on blind guessing to predict when a stock’s price will go up or down. The Relative Strength Index is one tool that active traders can use to predict how stocks or other assets may perform in the future. Created by an analyst named James Welles Wilder, Jr., in 1978, RSI measures how quickly and drastically an asset’s price has changed recently. This can help traders evaluate whether stocks are overvalued (trading above their real value) or undervalued (trading below their real value). Stocks that are undervalued might soon see a price increase, while overvalued stocks may see a decline. Knowing this information can help investors decide when to buy or sell securities in order to make a profit. RSI is an imperfect indicator and best used in partnership with other tools. Still, there is no guarantee it will lead you in the right direction, and trading is an inherently risky practice.
Let’s say a shoe store starts selling the latest must-have style for $50. As the style gets more popular, the store increases the price by $5 a day. After two weeks, the shoes cost $120. If the style is really only worth $50 (based on its price at other stores, for example), you might decide that the shoe is overvalued at this retailer. You would think twice before investing in a pair, because you would predict that the store would drop the price tag in the future (though there are no guarantees you’d be right). You may not have a fancy chart to go on, but you’re doing the same thing as a trader consulting the Relative Strength Index of an asset: tracking recent price changes in order to predict future ones and making investment decisions accordingly.
Using the Relative Strength Index is like trying to predict the next sale at your favorite clothing store…
If you’ve been following recent price changes for that sweater you’re eyeing, you may do a better job of predicting how much it will cost in the future. That way, you can try to buy it at the best time. There’s no guarantee you’ll make the right call, but you’ll likely be in a better position than if you walked in and blindly made the purchase.
Compiling the Relative Strength Index can get rather technical. RSI is calculated based on average price gain and average price loss, typically in a 14-day window. The goal is to predict where prices are going, not to signal how strongly a stock is performing.
The basic formula for calculating RSI is:
RSI = 100 – (100 / ( 1 + (Average Price Gain / Average Price Loss )) )
Because RSI involves crunching numbers for two weeks’ worth of data, it’s a complex equation that can be hard to do compute correctly by hand. Online RSI calculators make this easier: You enter the date, the price of your asset when the market opened, and the price when it closed. As you input data each day, the calculator adjusts the RSI value based on the length of time you determine.
The Relative Strength Index helps you try to tell the future based on how an asset performed in the past. Graphing RSI gives investors a general idea of whether an asset is overbought (overvalued) or oversold (undervalued). Values can range from 0 to 100.
The basic rule of thumb is that an RSI value over 70 indicates a stock is “overbought” and may see its price fall in the future. Meanwhile, an RSI value of 30 or lower can mean that the price will go up. Traders often decide to sell a stock when it hits 70 or buy when it gets to 30. An RSI of 50 is often seen as neutral, meaning the stock has not been either overbought or oversold.
Keep in mind that 30 and 70 are just general indicators. If an asset often exceeds an RSI value of 70 (remains overbought for a long time), you can use 80 instead. Sometimes an asset can be overvalued or undervalued according to RSI for a long time, but no price correction follows.
Investors also need to take market conditions into account. When the stock market as a whole is trending upwards (a bull market), RSI values are usually between 40 and 90. When it heads downward (a bear market), 10 to 60 is more common. Investors need to be well-informed and skilled at noticing even quite subtle fluctuations on the RSI graph.
The Relative Strength Index is presented as a graph, usually found along with a chart of the stock’s price over time. Comparing the RSI chart to price trends can provide investors with more information than RSI alone.
The y-axis (vertical axis) of the RSI chart shows the variation in RSI value, typically in the range of 0 to 100. Most graphs also have vertical lines at the 30 and 70 marks so you can easily tell if an asset is outside of that range (meaning it may be oversold or overbought). The x-axis (horizontal axis) of the chart shows the time period in question, generally 14 days.
As we all know from shoe shopping, trends sometimes happen thanks to intangible factors like human emotion. The Relative Strength Index can be helpful, but since many variables determine whether stock prices go up or down, it’s not a foolproof way to make predictions.
RSI looks at an asset’s recent price history, but the past is never a perfect predictor of the future. It is most reliable when the numbers align with long-term trends in the asset’s price. Trying to separate the signals from the noise to identify the exact moment when prices might go in the opposite direction is tough. And again, an asset can be overbought or oversold for a while without the price responding.
It can be a good idea to combine RSI with other indicators such as the Moving Average Convergence Divergence. MACD uses different Exponential Moving Averages (EMAs), which measure the relationship between recent price points, to help identify trend changes and momentum (whether a trend appears to be speeding up or slowing down).
An asset that is oversold is trading at a lower price than you would expect based on other measures of its value. In other words, it’s undervalued. Often, that means the price will increase in the future, but that doesn’t always occur right away or at all. The Relative Strength Index and other tools can help investors identify oversold stocks based on stock price behavior. An RSI value of 30 or below can signify that a stock is oversold. There’s no single definition of the term, so different analysts may come to different conclusions about whether a stock is oversold.
Another way to think of “overbought” is “overvalued.” This means that the price of the stock is too high compared to other value metrics or previous prices. There is a strong likelihood that the price will drop to correct the demand. A Relative Strength Index value of 70 or above can mean that a stock is overbought. Again, not all analysts will agree that a given stock is overbought, and the price may not drop in the near future.
A divergence is when an asset’s price moves in the opposite direction of what technical indicators like the Relative Strength Index or other metrics predict. When investors notice divergence, it’s a good sign that a trend in the asset’s price will soon slow or change direction. Positive divergence means the asset’s price may increase, while negative divergence suggests it may decline. But divergence isn’t always present when prices change course.
When the RSI of an asset leaves either oversold or overbought territory and approaches a neutral state, sometimes a bullish market (when stock prices as a whole are on the upswing) will reject this movement and send it back towards the threshold. Then, RSI will swing back and break its most recent record high. Investors who are skilled enough to observe the signs of an approaching swing rejection can capitalize on it to make a profit.
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