What is Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a common technical indicator used as a proxy to understand if a stock is overbought or oversold. It is a momentum indicator between 0 and 100 that measures the speed and size of a stocks recent price change. In technical analysis, a stock is usually believed to be overbought if the RSI is above 70 and oversold if the RSI is below 30.

The RSI indicator was created by J. Welles Wilder Jr. and introduced in his 1978 book, New Concepts in Technical Trading Systems.

How do you calculate the Relative Strength Index (RSI)?

The formula for the Relative Strength Index (RSI) is a little complex so I’ve broken it down into a couple of stages:

• Firstly, identify the time period/lookback period you want to use. Let’s take a simple example of 3 time periods.

• The next step is to calculate the Averages Gains and Average Losses over that time period using closing prices.

  • Let’s take a very simple RSI(3) example over 3 time periods:

  • Say T1 price = 10, T2 price = 11, T3 price = 9, T4 price = 8

  • T2 gain = 1 & T2 loss = 0

  • T3 gain = 0 & T3 loss = 2

  • T4 gain = 0 & T4 loss = 1

  • As you can see we’re taking the magnitudes for the gains and losses.

  • Then the Average Gain = (1+0+0)/3 = 0.33, Average Loss = (0+2+1)/3 = 1

• Relative Strength (RS) = Average Gain / Average Loss = 0.33/1 = 0.33

• Relative Strength Index (RSI) = 100 - [100/(1+RS)] = 100 - [100/1.33] = 25

The calculation with the first 3 periods use this approach with a simple average. The second 3 periods and onwards use a smoothing mechanism which places stronger weight on the most recent gain or loss.

• Let’s now say that we have T5 = 7, then the current gain = 0, current loss = 1 (because T4 was 8)

• Then the new Relative Strength (RS) = ((Previous Average Gain x (Number of period lookback - 1)) + Current Period Gain) / ((Previous Average Loss x (Number of period lookback - 1)) + Current Period Loss)

• ((Previous Average Gain x 2) + Current Gain)/((Previous Average Loss x 2 ) + Current Loss) = ((0.33 x 2) + 0)/ ((1 x 2) + 1) = 0.22..

• Relative Strength Index (RSI) = 100 - [100/(1+ New RS)] = 18.18

As you can tell here, even if you look at the RSI calculation using a 3 day window, it still takes into account even older days values using the ‘previous average gain’ but at a decaying rate. Currently (as of August 2023), Composer uses up to 1000-day look-back window to minimize error.

This is a simple example with RSI(3) however a 14-day RSI is the most commonly used. Once you have a series of RSI values, you can then plot is on a graph as a momentum oscillator (line graph to measure the momentum of the stock).

How do you interpret the Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is one measure to understand whether a stock is overbought/oversold. The overbought condition is usually when the RSI value is greater than 70 and then starts to point lower, it can indicate a bearish signal and the chance of a downtrend trend reversal. On the other hand, the oversold condition is usually when the RSI value is less than 30 and can indicate a bullish signal and a potential uptrend.

However these values are somewhat arbitrary. Well-known market technician Constance Brown, proposed that an oversold condition is likely to be much lower than 30, and an overbought condition is likely to be much higher than 70. (2)

How can you use the Relative Strength Index (RSI) in a stock trading strategy?

The overbought/oversold strategy above is a common stock trading strategy using RSI bands.

Other RSI stock trading strategies include:

• 50-crossover - Using the centre value of RSI to confirm if a price trend is occurring or not. If RSI deviates from this value, there could be price action.

• RSI Divergence - This strategy looks for the divergence between RSI and the market price. If the RSI moves in a different direction to the momentum (RSI), this could signal potential short-term buying and selling opportunities.

  • When the price hits a ‘higher high’ but the RSI makes a ‘lower high’ – this is bearish divergence.

    When the price makes a ‘lower low’ and the RSI forms a ‘higher low’ – this is bullish divergence. (3)

Composer is a stock trading platform with a community of over 1,000+ user-built strategies on their Discover page. Here's some examples of user-built stock trading strategies that use RSI.

• This strategy “Mean Reversion Comparison to Python Code” (link) uses the 10d relative strength index of TQQQ and if it’s less than 79, it invests in TQQQ otherwise it invests in another asset (SPY or UVXY).

• This strategy “TQQQ For The Long Term” (link) uses a combination of IF statements and multiple RSI comparisons. One interesting part of the strategy looks at whether the 10d RSI of UVXY is between 74 and 84 to invest in UVXY. If it’s greater than 84, the strategy shifts into other assets.

What are the limitations of Relative Strength Index (RSI)?

As a leading momentum indicator, RSI may not be a strong measure to understand short term price movements. For example, if the RSI moves towards a bearish signal and is above 70, it may stay in an overbought position for longer than expected. As such, there may not be an immediate price reversal.

RSI also doesn’t help to understand the size of price reversals if they do happen.

What are similar indicators to Relative Strength Index (RSI)?

RSI is a momentum indicator. Another momentum indicator is MACD (Moving Average Convergence/Divergence). MACD shows the relationship between two exponential moving averages (EMA) of a securities price. Other momentum indicators include: ADX (Average Directional Index), ROC (Rate of Change), Stochastic, and RS (Relative Strength).

Sources

• 1) https://www.investopedia.com/terms/r/rsi.asp

• 2) Constance M. Brown. "Technical Analysis for the Trading Professional." McGraw Hill Professional, 2012.

• 3) https://capital.com/relative-strength-index#:~:text=RSI%20trading%20strategies%20include%20(but,retracements%20may%20enhance%20market%20analysis.