Relative strength index: signals and usability

After the moving average and the moving average convergence/divergence, the RSI will be the third technical indicator on which I spend an article. The RSI, or Relative Strength Index, is one of the most used technical indicators. The RSI is, just like the moving average and MACD, an objective, mathematical technical analysis method.

What is the RSI?

The RSI indicator measures the speed and direction of change of a share. It does this by using different components, namely: RS, the average gain and the average loss of a period. As a default, the RSI is calculated over a 14 period timeframe (14 days or any other period). I will now explain the different components that makes out the RSI indicator.

The first average gain of a period, is the sum of all gains over the chosen period, divided by the number of chosen timeframes. As said, usually it will be 14 periods. The calculation will then be:

Average gain of a period = Total gains over 14 timeframes / 14

The gain mentioned in the formulae is the gain in a certain period. So if the period is a day, then the rise of one day should be used. It is important to know that you will only use the days in which the stock has gained in the calculation, and not the days in which the stock has declined.

The first average loss of a period is the sum of all losses over the chosen period. The average loss is calculated just like the average gain, but with the losses instead of the gains.

For subsequent average gains and losses, you should use the results of the first average gains and losses. The calculation of the subsequent gains will then be:

Average gain of a period = ((First/previous average gain * 13) + current gain) / 14

This calculation is the same for the subsequent average loss of a period.

When the average gain and loss of a period are calculated, the RS can be calculated. The RS is calculated by dividing the average gain of a period by the average loss of a period. The formulae for the relative strength (RS) will be:

RS = Average gain of a period / average loss of a period

When the relative strength has been calculated, the relative strength index can be calculated. The calculation of the RSI is:

RSI = 100 - (100 / (1 + RS))

The RSI is then translated into a percentage. The higher the average gain relative to the average loss, the higher the RSI.

When all outcomes of the RSI are put in a graph, you can see an RSI-line. This line can be used as an indicator, but it does not give the most important signal.

What signals does the RSI give?

The RSI indicator gives two different signals, the overbought and oversold signal. When the RSI is 70 or higher, most technical analyst give the overbought rating to a share. When the RSI is 30 or lower, an oversold signal is given. An RSI above 50 gives a positive signal, below the 50 a negative.

When the RSI is moving upwards, the share is in an upward trend. When the RSI is going south, the stock will do the same. This means that you would like to buy a share when the RSI is moving upwards. But when the RSI indicator is crossing the overbought level, you should pay attention. It is likely that the trend will turn, because a lot of investors think the stock is overbought.

The logic behind this is, that when a share is overbought, lots of investors are buying the share. So this means you should probably not because the share is too expensive. On the other side, when the share is oversold, the momentum is bad for the share. But momentums are there to change, so may be this will be a great moment to buy the share.

How to use the RSI?

Besides the signals the RSI gives at different levels, you can also use the RSI line to perform some other (subjective) technical analysis. You can draw lines through the graph and find support and resistancelines, just like you can do with the graph of the shareprice. You may find outbreaks above the resistanceline or bounces of of the supportline. But this is not the way I like to use the RSI indicator.

I only use the RSI as an indicator. I rather would use the oversold and overbought signals of the RSI to choose the right moment to invest in a share. And I would certainly not use the RSI as the only indicator. If I would use the RSI at all...

As a definition of the RSI indicator, you see that the RSI is following the share. Just take a look at the calculation. It is just a rate of the positive and negative days and day results. This means that the RSI will always follow the shareprices. So I am very cynical about using the RSI.

How to prevent false signals?

As you would have guessed, I do not use the RSI as a single indicator. The RSI continuously gives signals that are multi-interpretable. Therefore, use the RSI with other technical analysis indicators and, of course, with fundamental analysis. To prevent false signals, use the methods that we describe for other articles, like the articles about moving averages and MACD.