Stock Market 101: Relative Strength Index

Overview:

1. What is the Relative Strength Index?

2. Formula of RSI

3. Limitations of RSI

What is the Relative Strength Index?

The relative strength index (RSI) is a momentum indicator used in technical analysis that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100. The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, "New Concepts in Technical Trading Systems." The traditional applications of RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.

The Formula for RSI

The relative strength index (RSI) is computed with a two-part calculation that starts with the following formula:

Limitations of the RSI

The RSI compares bullish and bearish price momentum and displays the results in an oscillator that can be placed beneath a price chart. Like most technical indicators, its signals are most reliable when they conform to the long-term trend. True reversal signals are rare and can be difficult to separate from false alarms. A false positive, for example, would be a bullish crossover followed by a sudden decline in a stock. A false negative would be a situation where there is a bearish crossover, yet the stock accelerated suddenly upward. Since the indicator displays momentum, it can stay overbought or oversold for a long time when an asset has significant momentum in either direction. Therefore, the RSI is most useful in an oscillating market where the asset price is alternating between bullish and bearish movements.

KEY TAKEAWAYS

1) The relative strength index (RSI) is a popular momentum oscillator developed in 1978.

2) The RSI provides technical traders signals about bullish and bearish price momentum, and it is often plotted beneath the graph of an asset's price.

3) An asset is usually considered overbought when the RSI is above 70% and oversold when it is below 30%.