The RSI (Relative Strength Index) indicates whether a stock is overbought or oversold. Its value can vary from 0 to 100. The lower the value, the more oversold the asset is, while the higher the value, the more overbought the asset is. It’s also used to follow price trends. An increasing RSI indicates an upward trend, while a decreasing RSI indicates a downward trend.
How to interpret the RSI indicator?
The common interpretation of the RSI indicator is that when its value is above 70, it is often referred to as an overbought situation. Some traders prefer to use the 80 mark as a threshold.
When the RSI value is below 30, it is considered an oversold situation. Again, some traders prefer to use the 20 mark as a threshold.
If the indicator oscillates horizontally around the 50 level, it means that the market trend is not strong. The 50 level is the middle line that separates the bullish and bearish territories of the indicator.
On the picture above, we can see that the best signal is the first buy signal. The RSI line remained below the 30 mark for a longer period of time than the other signals on the picture. This indicates that the market was oversold for a long time, calling for a more probable trend reversion.
An important note: the RSI indicator gives signals that tell if the market is oversold or overbought. However, it does not automatically indicate in which direction the market is going to move. During a strong trend, the indicator may stay in the oversold/overbought zone for quite a long time. The movement of the RSI indicator can sometimes be more important and insightful than its actual value.
How to calculate the RSI indicator?
To better interpret the Relative Strength Index, it is crucial to understand what it is made of and how it is calculated. The RSI is calculated from the last X points of a chart. This value is named the period. Note that it can be calculated on any sampling frequency, no matter the timeframe of the analyzed curve. Be it ticks, the second, the minute, the hour, the day, the week or the month, the RSI does not take into account the timefram considered.
Here is the formula to calculate the RSI over the last X points:
RSI(X) = 100 * H(X) / (H(X) – B(X))
In this calculation:
H(X) = average increase over the last X points
B(X) = average decrease over the last X points
X can be expressed in days, hours, minutes.
The RSI has no unit of measurement, it is adimensional. It is reduced to a base 100 and is a bounded indicator which evolves between 0 and 100. These two theoretical limits are very rarely reached, if ever.
It is important to acknowledge that the longer the chosen period is, the less sensitive the RSI is to price changes, whether upwards or downwards.
Trading Strategies with the RSI
It is impossible to trade consistently with the RSI alone as an indicator. The sole observation of the RSI can at best support a decision. Thus, we advise you to combine the RSI with other technical indicators such as the position of the price compared to Bollinger Bands or Moving Averages, and volume indicators such as the On Balance Volume to better take your decisions.