What is the Relative Strength Index? How to use RSI?

The Relative Strength Index (RSI) is a momentum indicator that measures the velocity and magnitude of stock price changes.

Developed by J. Welles Wilder Jr., the RSI uses the values of stock price gains or losses over a certain period. It calculates a number between 0 and 100 based on a specific formula.

Generally, an RSI over 70 indicates that a stock is overbought (its price is considered too high), while an RSI below 30 suggests the stock is oversold (its price is deemed too low).

The 30/70 threshold can sometimes be adjusted based on stock price trends, such as changing it to 20/80.

In most cases, the movement of the RSI will match the price movement of the stock, but sometimes divergences can occur. Investors need to have sufficient experience to evaluate the price trend indicated by these movements.

It is important to note that the calculation of the Relative Strength Index only uses price gain and loss data over a specific period.

Therefore, when evaluating a stock for buying or selling, you also need to consider additional financial indicators to make a comprehensive judgment.

This article uses Apple stock (AAPL) as a demonstration. It is not recommended that you buy this stock. Remember: The stock market involves risks, and investment requires caution.

How to Calculate the Relative Strength Index?

The equation for calculating the Relative Strength Index (RSI) is as follows:

Step 1: Calculate the daily price change

For day i, calculate the difference between the closing price on day i and the closing price on the previous day:

Δi = Closing Price {i} – Closing Price {i-1}

Step 2: Determine gains and losses

• Gains: If Δi > 0, then Gain{i} = Δi; otherwise, Gain{i} = 0.
• Losses: If Δi < 0, then Loss(i) = -Δi; otherwise, Gain{i} = 0.

Step 3: Calculate the average gains and losses

Set a period n (commonly 14 days) and compute the average gains and average losses:

• Average Gain = Sum of Gains over the past n days/ n
• Average Loss = Sum of Losses over the past n days / n

Step 4: Calculate the Relative Strength (RS):

RS = Average Gain / Average Loss

Step 5: Calculate the RSI:

How to Calculate RSI?

In this section, you can learn how to calculate the RSI value of AAPL.

We first find AAPL’s historical stock prices from Apple Inc.’s investment website.

To calculate the daily change in stock price, we subtract the previous day’s closing price from the current day’s closing price.

From the table,

• The average of stock price increases is: $19.52 / 14 = $1.394
• The average of stock price decreases is: $39.89 / 14 = $2.849

Therefore,

RSI = 100 – 100 / (1 + Average of Upward Price Change / Average of Downward Price Change)

= 100 – 100 / (1 + $1.394 / $9.973) = 12.26

This calculation indicates that the current stock price of Apple is in an oversold state (<30).

What is the significance of Using the Relative Strength Index?

The Relative Strength Index (RSI) is a popular technical analysis tool used to assess whether a stock or other financial asset is in overbought or oversold conditions.

Below are some common scenarios for using the RSI to judge market trends:

1. Overbought or Oversold

Overbought (RSI > 70): When the RSI exceeds 70, it suggests that the securities may be overvalued and could be due for a price correction or pullback. This condition indicates strong buying momentum, but it also raises the possibility of an impending reversal.

Oversold (RSI < 30): An RSI reading below 30 indicates that the asset may be undervalued, signaling a potential buying opportunity. This suggests strong selling momentum, which might precede a reversal to the upside.

This could indicate a potential rebound trend and that the stock price is undervalued, presenting a good opportunity for “buying low and selling high” for some investors.

The 30/70 indicator combination can be adjusted based on the actual price trend.

For example, if a stock’s RSI value stays around 70 for a long time, the indicator can be adjusted to 80 for trend judgment.

Similarly, the downward indicator can be adjusted to 20 for trend judgment.

2. Divergence

RSI divergence refers to the inconsistency between the price trend and the RSI trend when using the RSI for technical analysis. This divergence is often seen as a potential trend reversal signal.

Divergence can be classified into two types: bearish divergence and bullish divergence.

A bearish divergence occurs when the price reaches a new high, but the RSI does not. This indicates that although the price is rising, the upward momentum is weakening, possibly suggesting a downward trend.

A bullish divergence occurs when the price hits a new low, but the RSI does not.

This indicates that although the price is decreasing, the downward momentum is weakening, possibly suggesting an upward trend.

3. Failure Swing

Failure swings in the RSI are a specific pattern to predict possible market trend reversals.

They are independent of price action and are based solely on changes in RSI values.

Failure swings can be divided into two types: Failure Swing Top and Failure Swing Bottom.

Failure Swing Top: This occurs when the RSI first exceeds 70 (entering the overbought area), then falls back, rises again but fails to surpass the previous high, and subsequently falls below the low point between the two highs.

This forms a failure swing top, which is considered a sell signal, indicating a potential downward trend. On an RSI chart, this pattern resembles the letter “M”.

Failure Swing Bottom: This occurs when the RSI first falls below 30 (entering the oversold area), then rebounds, drops again but fails to reach the previous low, and subsequently rises above the high point between the two lows.

This forms a failure swing bottom, which is considered a buy signal, indicating a potential upward trend. On an RSI chart, this pattern resembles the letter “W”.

These two types of Failure Swings provide potential trading signals, but they should be approached with caution. It’s best to use them in conjunction with other technical analysis tools to enhance the accuracy of trading decisions.

What are the limitations of using RSI?

The RSI is a widely used technical analysis tool, but it also has some limitations.

RSI is generally more suitable for short-term investors.

For long-term investors, it is necessary to consider more fundamental aspects of a company to evaluate a stock’s value, such as profitability and overall business capabilities.

The limitations of RSI are summarized as follows:

• Misleading Overbought/Oversold Areas: The overbought (typically above 70) and oversold (typically below 30) areas of the RSI are not always accurate buy or sell signals. In strong trending markets, the RSI can remain in these areas for extended periods without necessarily indicating an impending reversal.
• Failure in Trending Markets: In sustained bull or bear markets, the RSI can give misleading signals. For example, in a strong upward trend, the RSI may consistently show an overbought condition, misleading investors into thinking that a market correction is imminent.
• Delayed Divergence Signals: Although RSI divergence can be a strong indicator of market turns, these signals often have a delay. This means that by the time a divergence is confirmed, the market may have already reversed for some time.
• Need for Combination with Other Tools: RSI is best used in conjunction with other technical analysis tools and indicators to enhance the validity of the signals. Relying on RSI alone may not provide sufficient trading signals.
• Subjectivity in Parameter Selection: The calculation of RSI depends on the chosen time period (such as 14 days, 10 days, etc.). Different parameter selections can lead to different results, increasing the subjectivity of the analysis.

By understanding these limitations, you could better use the RSI in combination with other indicators and techniques to make more informed trading decisions.

How to find Relative Strength Index?

Interactive Brokers is an international brokerage firm offering a wide range of trading and investment services, suitable for individual, professional investors, and institutional clients.

For a detailed introduction to Interactive Brokers, please refer to the article “Interactive Brokers Deposit and Investment Guide.”。

Here is an example using the IBKR web version:

On the Interactive Brokers homepage, log in to your IBKR account.

Find the stock you are interested in, here using AAPL as an example.

In the stock candlestick chart, find the menu item “Indicators”.

In the “Indicators” pop-up menu, type in “RSI”. From the search results, select “Relative Strength Index.”

Then the Relative Strength Index will be displayed below the candlestick chart.

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Disclaimer

NON-INVESTMENT ADVICE: The content provided here is for informational purposes only and does not constitute professional, investment, or financial advice. Always seek professional guidance tailored to your situation.

Risk of Loss: Trading securities and derivatives involves inherent risks, including the loss of principal. Past performance is not indicative of future results.

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