Understanding the Relative Strength Index (RSI)
If you’re getting into the investing world, you’ve likely come across, or soon will come, the term “RSI.” In this article, we’ll break down the basics of the Relative Strength Index and all it entails, explaining how it can benefit and boost your investment strategy.
What is the Relative Strength Index (RSI)?
The Relative Strength Index (RSI) is a vital indicator tool for many investors in the US and beyond. It’s used to look at how securities (also known as tradeable financial assets) are performing. So as you grow your investment portfolio and step into this sphere, it might benefit you.
First developed by J. Welles Wilder and introduced to his finance peers in the 1978 book “New Concepts in Technical Trading Systems,” the RSI is shown as a line graph of values from 0 to 100. The performance of a security according to the RSI is plotted based on the following:
A) The speed at which a security’s price changes in a given timeframe.
B) The amount that a security’s price changes in a given timeframe.
Using the RSI, you can compare recent losses and gains to determine how much momentum an asset has, spot patterns, and make smarter money choices (or, for that matter, your financial advisor can use the RSI to do these things for you).
You can avoid securities that are considered “overbought” or “oversold” and opt for securities with certain “undervalued” conditions that might allow you to profit. Usually, “overbought” assets will have an RSI indicator value over 70, while “oversold” assets will come in below a value of 30.
How is RSI calculated?
The RSI is a momentum-indicating tool. RSI figures for securities, which express how much momentum they have, are calculated using a two-part process.
Using closing market prices for the day, the first part of the process is the calculation for determining Relative Strength. This calculation divides average gains by average losses to find a value. For the second calculation and the final RSI value, that first calculation must be averaged across a standard period of 14 days. The equation is as follows:
A security’s RSI value = 100, minus:
100, divided by:
[The 14-day average gain, divided by:
The 14-day average loss]
It’s a complicated calculation, but these are the basics. Many specific, figure-based examples are available to help you make further sense of it, both online and in creator J. Welles Wilder’s book. Though it might initially seem overwhelming, this sort of financial estimation can be massively valuable to you if you can get your head around it.
How to use the RSI indicator
Once you, your financial advisor, or asset manager have calculated the RSI for a security, it can be plotted beneath that security’s price chart. You’ll usually see it rise as the number and magnitude of “up” days increases and fall when the same is true for “down” days.
The RSI indicator gives you a concrete way to track possible trends up and down, providing figures to show the direction of travel for a specific security. This is the biggest reason the RSI has become such a popular tool for investors! For example, an RSI above 50 could suggest a possible uptrend. While an RSI below 50 can mean a downward trend is in progress.
Why is RSI important?
Summarizing and distilling all we’ve discussed above, there are five key reasons why the RSI is so important for investors:
The RSI highlights assets that have been “overbought” or “oversold.”
The RSI can be combined with trendlines and other trading analysis strategies to give clearer, defined, and data-backed ideas about market conditions.
The RSI provides advance signals and warnings when prices are about to change, whether they will trend upward or downward.
The RSI allows investors to follow the rule of 50 (briefly mentioned above) and protect their profits.
The RSI gives short-term traders a clear idea of when to buy and sell while warning long-term traders of fluctuations they should be aware of.
How does the RSI impact me when I’m investing?
When used correctly, the RSI indicator will indicate when you should think about selling or buying a particular security. During strong trend phases, assets can remain “overbought” or “oversold” for long periods, so the sooner you become aware of a situation like this and do what’s necessary, the better for your finances.
The RSI isn’t the be-all and end-all of your investment journey. There’s every chance this momentum indicator will fail to catch something you wanted it to from time to time or will present you with data, only for that data to change rapidly based on the precarious, fluctuating nature of market conditions.
RSI indications can sometimes create false signals to act, as not every momentum change translates to a price change. Plus, when a reversal happens, there’s no way for the RSI to track the size of that reversal before it happens.
Like any indicator, investment tool, or financial trick, the RSI has its pros and cons and should form part of a more comprehensive, well-considered investment strategy. If you’d like to create a new strategy or find a financial advisor for managing your investment portfolio, Unbiased can find the perfect expert to meet your needs.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.