An Introduction to the Relative Strength Index (RSI)

The Relative Strength Index (RSI) of a security or commodity attempts to measure its momentum. Namely, the formula is used to estimate whether the stock has been overbought or oversold, which could falsely affect price even if the underlying asset has held relatively constant. The RSI was developed by J. Welles Wilder in an article for Commodities magazine in 1978. It is a simple technical formula that uses a scale of 0 to 100 to indicate the momentum of the security.

Formula for RSI

The formula for RSI is simple:

RSI = 100 - (100/relative strength)

In this case, relative strength (RS) is a ratio of the average of the up closes over down closes over a certain period of time. For example, if an analyst wanted to measure the RS of Stock A over 30 days, they would take the average up closes of a 30 day period over the average down closes over the same period. Once the RS is found, it is factored into 100, and subtracted from 100. The result is a number from 0 to 100. A security is considered  to be overbought when the RSI is above 70, and oversold when the RSI is below 30.

RSI Example

Stock A has been purchased and sold over a 10-day period. Over those 10 days, the prices have been as follows:

$3, 4, 6, 3, 2, 4, 4, 3, 5, 5

  • First, calculate the average gain on up closes: (1 + 2 + 2 + 2) / 4 = 1.75
  • Next, calculate the average loss on down closes: (3 + 1 + 1 ) / 3 = 1.67
  • Now, calculate RS: 1.75/1.67 = 1.05
  • Finally, calculate RSI: 100 - (100/1.05) = 4.76

The security has been oversold.

Using RSI to Pick Securities

When a security has been oversold, the market has been flooded with sell orders. This can falsely decrease the price even if the value of the asset is still strong. An oversold asset is a "value" asset. Once the market corrects for this over-selling, the price of the security is likely to rise again. This security is likely to outperform its competitors.

If a security has been overbought, it may be valued higher than what other factors would indicate is a "fair" price. The stocks of well-known, large, growth companies are often overbought. Even though they may present some dividend payments, the likelihood for large capital gains is reduced because the price is already very high. As a result, it is wise to avoid overbought stocks.

Limitations of RSI

RSI is a relatively limited factor for estimating the market momentum of a security. It can be easily thrown off if the price of a security experiences a very large surge or drop in price, even if this change is extremely temporary. As a result, it is best used in combination with other market indicators. Ask your broker about the RSI of a particular security for insight into its popularity, but be sure to consider the value of the underlying asset instead of picking a stock based on RSI alone.

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