Definition of ‘RSI Indicator’ - The Relative Strength Index (RSI) is a momentum indicator that measures the magnitude of recent price changes to analyze overbought or oversold conditions.
What is an RSI indicator?
The Relative Strength Index (RSI) Definition — The Relative Strength Index (RSI) is a momentum indicator that compares the magnitude of recent gains and losses over a specified period to measure the speed and change of price movements of a stock. It is primarily used to identify overbought or oversold conditions in trading an asset.
The RSI was developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, New Concepts in Technical Trading Systems. It has since become one of the most popular oscillators in the analysis of financial assets.
The RSI computes momentum as the ratio of higher closes to lower closes: stocks with more or more substantial positive changes have a higher RSI than stocks with more or more significant negative changes.
RSI indicator can be used on any freely traded asset such as stocks, bonds, commodities, or currencies; it applies to various other data series such as volatility or market breadth to analyze market conditions.
How do you read an RSI indicator?
When the RSI is above 70, the market is overbought, indicating a potential sell signal. In contrast, when the RSI indicator falls below 30, it indicates an oversold condition, and traders can look for buying opportunities.
The default setting for RSI is 14-period, which can be applied to any time frame. So, for example, you can use it on a 5-minute or daily chart.
In addition to the 14-period RSI, there are other standard settings: 9 and 25-period.
The nine-period RSI is more responsive and appropriate for short-term trading (scalping). It will give many more trading signals than the 14-period. However, the 9-period RSI gives many false signals because it is more sensitive to price movements.
However, the 25-period RSI is less responsive and is more appropriate for long-term trading and investing.
Furthermore, divergence occurs when the underlying security price makes a new high or low while the RSI fails to do so. While this situation does not necessarily indicate that a market reversal is imminent, it does show that the market is weakening and the current trend could potentially reverse.
There are two types of divergences:
Bullish divergence is usually considered as a sign of weakness in the prevailing market trend, which warns that it may be about to reverse direction. The implication is that upward movement in price will follow. Bullish divergences often occur at or near support levels, increasing their predictive value.
Bearish divergence is usually considered as a sign of strength in the prevailing market trend, which warns that it may be about to reverse direction. The implication is that a downward movement in price will follow. Bearish divergences often occur at or near resistance levels, increasing their predictive value.
Relevant reading: Accumulation/Distribution Indicator
What is a good RSI indicator?
A good RSI indicator will show an upward trend when the price is above the 30-level, and it should show a downtrend when the price is below the 70-level.
As such, it makes sense for traders to use this indicator as a trigger for entering into trades or setting stop losses.
The problem with the RSI is that it can be prone to whipsaws and false signals, which can pose problems for traders who want to rely on this indicator in isolation.
Calculate the first period's average gain using the following formula:
1st Period's Avg Gain = Sum of Gains over the past 14-period / 14
Calculate the first period's average loss using the following formula:
1st Period's Avg Loss = Sum of Losses over the past 14-period / 14
What time frame is best for RSI?
The power of the RSI indicator lies in its versatility. You can use it to set oversold and overbought levels or identify divergences that could signal a trend reversal or continuation.
The time frame you are using will depend on your investment goals. If you're a day trader looking for short-term gains, then using an intraday chart such as 15-minute, 30-minute, or 60-minute will suit your needs. If you are a swing trader looking for intermediate opportunities, a daily chart would be more appropriate. And if you are an investor with a long-term outlook, then a weekly or monthly chart could help you identify significant turning points in the market.