Introduction to RSI
The Relative Strength Index, or RSI, is a technical momentum indicator developed by J. Welles Wilder Jr. and introduced in his 1978 book, New Concepts in Technical Trading Systems. It is designed to measure the velocity and magnitude of recent price movements to evaluate overbought or oversold conditions in stocks or other assets.
Unlike absolute price changes, RSI oscillates between 0 and 100, providing a relative context of price strength. Traders use it to spot potential turning points, confirming trends, and gauging momentum shifts.
How RSI is Calculated
The RSI calculation involves comparing average gains and average losses over a specified period, typically 14 periods (days in daily charts). Here's the formula step-by-step:
1. Calculate the change in price from one period to the next.
2. Separate the changes into gains (positive changes) and losses (negative changes).
3. Calculate the average gain and average loss over the 14 periods.
4. Compute the Relative Strength (RS): RS = Average Gain / Average Loss
5. Calculate RSI using: RSI = 100 - (100 / (1 + RS))
The RSI value moves between 0 (extremely oversold) and 100 (extremely overbought).
Interpreting RSI Values
- Overbought: RSI above 70 often suggests the stock may be overbought and due for a pullback or consolidation.
- Oversold: RSI below 30 may indicate the stock is oversold and could be poised for a reversal or bounce.
- Midline Crosses: RSI crossing above 50 can signal strengthening momentum, while crossing below 50 can indicate weakening momentum.
Note that these levels are guidelines, and context matters. Some stocks or sectors may sustain high or low RSI for extended periods during strong trends.
Practical Steps to Use RSI in Trading
Follow this checklist to apply RSI effectively:
- Step 1: Select RSI Parameters – Use the default 14 periods for most cases; adjust if you want faster or smoother readings.
- Step 2: Identify Overbought/Oversold Zones – Watch for RSI crossings above 70 (overbought) and below 30 (oversold) as initial signals.
- Step 3: Confirm Signals With Price Action – Look for supporting evidence such as resistance/support levels, candlestick patterns, or volume spikes to validate RSI signals.
- Step 4: Watch for Divergences – RSI divergences happen when price makes new highs/lows but RSI does not, which can indicate weakening momentum and potential reversals.
- Step 5: Combine with Trend Context – In a strong uptrend, RSI may remain above 50 for longer; use RSI drops below 50 cautiously. Reverse applies in strong downtrends.
- Step 6: Set Entry and Exit Rules – Define how you will enter on oversold signals (e.g., RSI crosses back above 30) and where to place stop-loss orders.
Worked Example: Trading with RSI
Suppose you analyze stock XYZ with a 14-day RSI currently at 25 (oversold region). Here's a step-by-step approach:
- Check Price Action: The stock recently declined sharply but is approaching a previous support level on the chart.
- Wait for RSI Confirmation: You wait for RSI to rise back above 30, indicating the oversold pressure may be easing.
- Entry Signal: Once RSI crosses above 30 and the stock forms a bullish candlestick near support, you initiate a buy order.
- Set Stop-loss: Place a stop-loss a few cents below the support level to limit downside risk.
- Profit Target: Consider exiting as RSI approaches 70 or if price hits a known resistance level.
- Trade Management: Monitor RSI and price for signs of weakening momentum or reversal.
Common Mistakes When Using RSI
- Ignoring Trend Context: Swinging solely on RSI extremes without considering overall trend can lead to premature trades. For example, oversold RSI in a strong downtrend may not signal a buy.
- Over-relying on Fixed Thresholds: Blindly using 70/30 without adjustment can produce false signals. Some stocks may run hot with RSI above 70 for long periods.
- Neglecting Confirmation: Entering trades based on RSI alone without looking at volume, price patterns, or support/resistance weakens the signal’s reliability.
- Ignoring Divergences: Missing divergences can lead to missed chances or entering at the wrong time. Divergences are a valuable complementary signal.
- Overtrading: Reacting to every RSI dip or spike can cause excessive trading and costs. Patience and discipline are critical.
Practice Plan (7 Days) to Build RSI Skills
- Day 1: Learn how RSI is calculated and plot RSI on a charting platform for your favorite stock.
- Day 2: Identify historical overbought and oversold zones and mark price reactions.
- Day 3: Study examples of RSI divergences and label them on charts.
- Day 4: Compare RSI signals during trending vs. ranging markets; note differences.
- Day 5: Backtest a simple RSI-based trade entry and exit strategy on historical data.
- Day 6: Monitor real-time RSI movements throughout the trading day to observe live momentum shifts.
- Day 7: Write a brief summary of how RSI influenced your trade decisions and note improvements for next week.
Conclusion
The Relative Strength Index is a versatile, easy-to-use momentum tool that can improve your ability to spot price extremes, confirm trend strength, and anticipate reversals when used properly. Incorporate RSI thoughtfully into your broader trading framework by combining it with price action, volume, and risk controls. Avoid common RSI mistakes by respecting trend context and focusing on confirmation signals. With practice, RSI can become an essential part of your technical analysis toolkit for more informed, disciplined trading.