The RSI is an oscillator-type indicator which varies from 0 to 100 and serves to indicate overbought and oversold zones. RSI means Relative Strength Index and it was developed by J. Welles Wilder in the late 70’s and is one of the most popular and helpful oscillators used in technical analysis. Their values are obtained by comparing the gains against the losses of previous sessions (14 is the period recommended by Wilder).
This indicator was first come into the market through the book “New concert in technical trading system”. It is specially designed to chart the current and historical strength or weakness of the market.
RSI Calculation and Formula
The formula for RSI is:
-RSI = 100 – 100 / (1 + RS)
Where:
-RS = average profit / average loss for the period of calculation.
-Average earnings = [(previous average gain) x 13) + current gain] / 14 (the first average gain of the series is the arithmetic mean of the 14 previous sessions).
Substituting earnings by losses it gives the average loss. For losses it is used the absolute value.
As with the Average True Range (ATR), an indicator also developed by Wilder, the calculation is sensitive to the amount of historical data that we have because, as shown in the formula, the first data is not calculated in the same way as the following. The first calculation of the RS is a simple average of the total gains or losses while the following calculations are made using the previous average. This is the smoothing technique used by Wilder in almost all indicators developed by him.
From the formula of RS is deducted that when the average gain is greater than the average loss, the value of RSI will increase because the division profit / loss is greater than 1, while the RSI will decrease in the opposite case as the result of the division is less 1.
Once the RS is calculated, the RSI is obtained by converting the result to a scale of 0 – 100. It should be noted here that in case of loss becomes zero RSI is 100 by definition.
Uses of RSI
Overbought and oversold zones
Wilder recommended the use of levels 70 and 30 as levels to detect overbought and oversold conditions. Generally, if the RSI rises above 30 from below is considered that the instrument is in an uptrend. On the contrary, the instrument will enter in a downtrend if the RSI falls below 70 from above. This is because if the RSI is above 70 it says we are in an overbought market and if the RSI is below 30 it is said that the market is oversold. One tactic followed by many traders is to detect long-term trend and look at the RSI extremes to enter the market. For example, if the main trend is bearish and the RSI readings are above 70, that could provide good entry points into the market.
Divergences among price and RSI
As in many other oscillators, divergences, both positive and negative, between the RSI and price can generate buy and sell signals.
- Bullish Divergence: It occurs when a minimum price makes less than previous low while the RSI makes a minimum higher than the previous low. The bullish divergence is a very good sign to open a long position (buy).
- Bearish divergence: This divergence occurs when we see a maximum price higher than the previous high and the RSI shows a maximum below the previous peak. The bearish divergence is a very good signal to open a short position (sell).
The following, are two examples of RSI-price divergences:
More information on this useful technical indicator in the following article:
-RSI Indicator Guide for Traders
