How to Calculate the Relative Strength Index (RSI)
Learn to fully comprehend the Relative Strength Index (RSI). This guide offers deep insights into its methodology and practical application.
The Relative Strength Index (RSI) is a momentum oscillator used in technical analysis to evaluate the speed and change of price movements. It helps market participants identify conditions where an asset may be overbought or oversold. The RSI is typically displayed as a line graph, oscillating within a defined range, commonly between zero and 100.
Understanding RSI Components
Calculating the Relative Strength Index requires understanding its foundational components: average gain and average loss. These components are derived from the closing prices over a specific look-back period, most commonly 14 periods. A “gain” occurs when the current closing price is higher than the previous closing price, while a “loss” happens when the current closing price is lower. Periods where the price remains unchanged or moves in the opposite direction are counted as zero for the respective gain or loss calculation.
To begin, you calculate the initial average gain and average loss for the first 14 periods. This is done by summing all positive price changes for the average gain and summing the absolute values of all negative price changes for the average loss, then dividing each sum by the number of periods, which is 14. After these initial averages are established, subsequent calculations involve a smoothing process. This smoothing incorporates the previous average and the current period’s gain or loss to create a continuous data series.
The smoothing formula for subsequent average gains and losses is: [(Previous Average Gain/Loss) (n-1) + Current Gain/Loss] / n, where ‘n’ is the number of periods, typically 14. This method gives more weight to recent data while still incorporating the history of price movements. By consistently applying this smoothing, the average gain and average loss values become more representative of the ongoing momentum, providing the necessary inputs for the final RSI formula.
Performing the RSI Calculation
Once the average gain and average loss have been accurately determined, the next step involves two sequential calculations to arrive at the Relative Strength Index. The first calculation establishes the Relative Strength (RS), which represents the ratio of the average gain to the average loss. This ratio quantifies the strength of upward price movements relative to downward price movements over the chosen period.
The formula for Relative Strength (RS) is simply: RS = Average Gain / Average Loss. For instance, if your calculated Average Gain is 0.75 and your Average Loss is 0.25, the Relative Strength would be 0.75 divided by 0.25, resulting in an RS of 3.0. This RS value directly feeds into the final RSI formula.
The second and final step converts the Relative Strength into the Relative Strength Index, which is scaled from 0 to 100. The formula for RSI is: RSI = 100 - [100 / (1 + RS)]. Using the previous example where RS was 3.0, the RSI calculation would be 100 – [100 / (1 + 3.0)], which simplifies to 100 – [100 / 4.0], resulting in 100 – 25, yielding an RSI of 75. This numerical value is what traders interpret to assess momentum.
Interpreting RSI Readings
The calculated RSI value provides important insights into an asset’s price momentum, ranging from 0 to 100. Traditionally, readings above 70 indicate that an asset may be overbought, suggesting that its price has risen too quickly and could be due for a correction or reversal. Conversely, an RSI reading below 30 suggests an oversold condition, implying that the asset’s price may have fallen too far and could be poised for a bounce or upward reversal.
The RSI can also reveal divergences between price action and momentum, signaling potential trend reversals. A bullish divergence occurs when an asset’s price makes a new lower low, but the RSI makes a higher low, indicating weakening selling pressure and a potential upward trend change. Conversely, a bearish divergence happens when the price forms a new higher high, but the RSI makes a lower high, suggesting waning buying momentum and a possible downward reversal.
The 50-level on the RSI acts as a centerline, providing insights into trend direction. An RSI consistently above 50 suggests bullish momentum, while readings below 50 indicate bearish momentum. During strong uptrends, the RSI remains in the 40-90 range, with the 40-50 zone acting as support. In strong downtrends, it stays between 10 and 60, with the 50-60 range acting as resistance. A break across the 50-level can signal a shift in the prevailing trend.