The relative strength index (RSI) is one of the most widely used technical indicators as a tool to identify strength or weakness in the trending of a security or asset. It is typically used as a gauge to define oversold and overbought levels.
The relative strength index (RSI) was developed by Welles Wilder in 1978 and is considered a momentum indicator. It is a type of oscillator to measure the speed of trend but not the direction. It finds a ratio between the average of negative and positive price movements over a specified time period which is typically 14 periods.
The result of RSI is displayed as an oscillator between 0 and 100. A reading of 100 indicates the security traded higher within the recent trading period, while a value of 0 indicates the security traded lower over the specified time period.
Scenarios where traders may measure the overbought and oversold levels for the RSI is at values of 70 or greater for the overbought level, and 30 or less for the oversold level. When a security is trading within these ranges and reaches either level, there may be a reversal of price in the recent direction.
RSI is typically calculated with standard period of 14 days, but can be shortened or extended depending on the features of the security or asset and the overall strategy. That said, RSI is often used in conjunction with other technical indicators.
The traditional interpretation of the RSI is that it is considered overbought when above 70 and oversold when below 30. While this may be effective, values may also range between 80 and 20 or 90 and 10. This serves to capture additional information on the strength of the security or asset.
In terms of values, Wilder suggested that a value of over 70 can signal a market top, while a value of below 30 can alert of a potential market low. With that said, the role of RSI is to signal a potential trend reversal, not for forecasting price direction.
In many cases, the RSI will look to confirm price trends. As the RSI reaches overbought levels, the indicator can be used to predict that the security may be charged with higher valuation, and inverse, oversold, it is indicative of an opportunity to buy.
Understanding the relative strength index (RSI) is integral to developing effective strategies and maintaining good technical analysis. It gives an essential insight into whether the price of a security or asset is likely to continue the current trend or reverse.
RSI is a tremendously useful and simple trading tool, when used correctly. Getting to know the fundamental concepts to develop strategies and characterise the overbought and oversold levels are critical in understanding the strength in trending of a security. This leads to a less volatile, consistent and profit generating approach.
