The relative strength index is a popular technical indicator that determines whether a stock is overbought or oversold. The RSI is an important tool to analyze a security’s recent trading activity. The RSI oscillates between zero and 100. It measures the number of recent price changes and can have a reading from 0 to 100.
The indicator was originally developed by J. Welles Wilder Jr. in 1978.
The RSI Formula
Simply put, below is the high level formula but computed through averages.
RSI = 100 – (100 / (1 + RS))
Relative Strength (RS) = Average Gains / Average losses over a period. This RSI calculation is based on 14 periods.
- Average Gain = Sum of Gains over the past 14 periods / 14
- Average Loss = Sum of Losses over the past 14 periods / 14
Then a smoothing technique is applied based on prior and current averages.
- Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
- Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.
A period of 9-14 days is ideal for RSI day trading sessions. As the time period is reduced the chart becomes more sensitive, while increasing the number of days makes the data less responsive. A user can increase or decrease the time period depending on his strategy.
How to read the RSI
The usage is very simple.
- A reading of more than 70 indicates that the stock is in the overbought category.
- A reading of less than 30 indicates that a stock is oversold/ undervalued.
- A reading of 50 indicates a neutral position.
The RSI generally stays above 30 and should frequently hit 70 during an uptrend, whereas during a downtrend the RSI is near 30 or below and rarely exceeds 70. The RSI may remain in the overbought or oversold categories for long periods during strong trends.
If the RSI fails to hit 70 on a few straight days during an uptrend and falls below 30, this means that the trend has reversed.
Similarly in a downtrend, if a stock is unable to reach 30 or below and moves above 70 subsequently, it indicates a trend reversal. A rising/ strong market trend is indicated by a movement from below the centerline (of 50) and vice versa.
RSI 14 days is the most commonly used metric. An RSI of 0 means that the stock price has fallen in all of the 14 trading days while an RSI of 100 means that the stock price has gained in all 14 days.
Analyzing the RSI Trends
Failure Swings – Failure Swings are helpful in understanding the trend reversal and indicates initiating a long/ short position. Say a stock has already touched 70 but then falls to 60 (fail point). It moves up again but is below the 70 mark and later falls to below 60. This is called a bearish failure swing/ bearish swing rejection and signals initiating a short position. The reverse is a bullish failure swing/ bullish swing rejection and provides an indication for starting a long position in the security.
Divergence – When the RSI and price of a security move in an opposite direction, it creates a divergence and signals market correction.
Entry & Exit Points – One should create a long position ideally when the RSI falls below the 30 level but subsequently starts moving above the 30 level. Similarly, consider creating a short position when the RSI falls to the 70 level and then starts to move below the 70 level.
Pros of RSI
- Provides signals about bullish and bearish price momentum.
- RSI can be used to identify the general and key reversal trends.
- Better indicator in a fluctuating market where the asset price is alternating between bullish and bearish movements.
- Easy to understand.
- Helps in identifying the potential entry and exit points.
- Popular for day trading.
Cons of RSI
- Solely dependent on the prices during a recent period.
- RSI signals come after a price event on the chart, many of these signals can be misleading or premature.
- RSI is indicative and not fool-proof. It does not take into account the events that affect a stock’s price eg. earnings, news, etc.
Should you use the Piotroski Score?
The Piotroski Score is a great tool to find out solid stocks with improving financials, improving margins and strong balance sheets.
However, the Piotroski Score should be used in conjunction with other metrics. Remember all cheap stocks are not necessarily ‘value stocks’ and the Piotroski Score is only one view into the company’s financial strength.
Though it is a useful tool for value investors it cannot be used alone to make investment decisions.
Should you use the RSI score?
The RSI indicator is best used in combination with other technical indicators to identify opportunities to enter or exit a position. An RSI rising above the 30 mark indicates a bullish signal and below the 70-mark is a bearish signal.
Further, investors can take cues by analyzing divergences and failure swings. RSI should be used together with other indicators such as volume and overall stock markets trend. When used properly, the RSI has the ability to show price trends, when a market is overbought or oversold.
How Dividend Earner Uses The Price to RSI Score
While I don’t pay much attention to valuation and what the price should be when I buy, the RSI can help indicate if you should be more patient before buying. I have no hard rules on the RSI but it can help as a tie breaker.
Frequently Asked Questions
What is a good RSI number?
An RSI of 70 or more suggests that a security is becoming overvalued and indicates a corrective price pullback. An RSI of below 30 indicates an undervalued condition.
What does RSI 14 mean?
When the RSI is calculated on a 14-days timeframe it is known as RSI 14. It is the most commonly used. The time period can be shorter or longer.
What is the range for RSI?
RSI can reach values from 0 (bearish market) to 100 (bullish market). During a bull market, RSI values are normally in the 40 to 90 range and 10 to 60 range, in a bear market.