Stock investors are always trying to gain an edge on the market, and a popular way to do so is to apply economic metrics to the stocks they like - before pulling the trigger and buying them.
One of the most effective market measurement metrics - the Relative Strength Indicator - has actually been around for decades, yet sometimes flies under the radar compared to other stock measurement tools, like valuations, weighing balance sheets, and price-to-earnings ratios.
In fact, the RSI is a great way to measure a stock's potential, and the better you understand how RSI works, the more you can start benefiting from one of the most underrated, but most effective stock market calculation tools available.
What Is RSI?
Simply stated, the RSI measures recent performance of a given stock against its own price history performance, by combining the average gain or loss a particular security owns over a predetermined time period. Investors usually rely on the RSI to figure out whether a stock is oversold or overbought.
While market analysts usually use the RSI to measure a stock's trading trends, the technical analysis tool can also measure the relative strength index of bonds, options, futures, commodities, and currencies, as well.
The RSI was created by J. Welles Wilder, a real estate investor, and first made public in a 1978 book on financial trading analysis called "New Concepts in Technical Trading Systems." Wilder's work on the RSI was also featured in Commodities Magazine, also in 1978.
What Is the Oscillator Model?
To truly understand the RSI, you need to understand the term "oscillator" and how oscillators work.
In stock market terms, an oscillator is a technical analysis measurement metric that weighs a stock's performance between two extreme points (i.e., low purchase points versus high purchase points.) The idea is to lock in a trend indicator based on the oscillator model and determine ideal conditions to buy a stock, based on whether or not a stock is overbought or oversold.
With RSI, the oscillator is a band between one and 100, and is usually measured over a two-week time period, with high (70) and low (30) levels factored into the equation (although trading ranges between 20 and 80, or 10 and 90, are not uncommon.) As the oscillator slides upward toward 100, the data is telling the investor that the stock is in "overbought" mode. Conversely, when it slides downward toward zero, the takeaway is that the stock is likely oversold.
The oscillator model is particularly useful for stock market analysts when a stock is meandering, price-wise, in a narrow band. When a stock is generally trading horizontally, it's more difficult to peg a trading trend on the security, and it's necessary to turn to so-called stochastic oscillators, like the Relative Strength Indicator, as a more accurate stock performance indicator.
Note that the RSI is not same as relative strength, a stock market measurement that checks a stock's performance against a specific index, like the Standard & Poor's 500.
Overbought Vs. Oversold
To master the RSI formula, you'll need to properly evaluate overbought versus oversold securities.
A security is considered "overbought" when demand for a stock or other investment vehicle leads to more buyers than sellers trading the security, which leads to a higher share price.
With the RSI, the goal is to ascertain when stockholders know that their stock is overbought, and may well decide to lock in profits and sell the stock before sentiment turns bearish and demand for the stock weakens. The RSI can provide a good indicator of approximately when a stockholder will sell in a high-demand market scenario.
Conversely, a security is oversold when demand for it recedes, possibly after bad news about the underlying company goes public or if economic or industry trends derail a company's financial performance.
If a stock declines in value for no crystal-clear reason, the RSI can be invaluable in pegging an approximate point where the share price slides so far down the band that the stock likely is oversold, and represents a good buying opportunity. Figuring out when the optimal time to buy a stock in decline is a job made easier with solid RSI technical analysis review.
Again, when the SRI lands above 70 or below 30, that means a security is either overbought (at 70 or over) or oversold (or 30 or under.) Market analysts believe that means a correction is in order, and the security will reverse course.
How to Calculate RSI
As a momentum indicator, the RSI can be a great tool to let an investor know when a security should be bought or sold, particularly in overbought or oversold market scenarios.
The calculus for making a "buy" or "sell" determination is as follows:
RSI = 100 - 100/ 1 + RS
Basically, the formula is broken down into several key categories:
- The average gain.
- The average loss.
- The RSI.
Take a typical 14-day stock market trading period.
In that scenario, the average gain is the same as all total gains, divided by 14. Let's say an investor records only three losses during the 14-day period. Here, the total of those three trading session losses is divided by the amount of RSI trading sessions (14, under this scenario). The average loss is calculated in the same manner.
Your RSI value is calculated by dividing the average gain by the average loss.
By and large, as a stock rises in price, the RSI will spike upward, too. That's due to the fact that average posted gains will override average losses.
When a stock declines in price, losses will outpace any performance gains, which leads to the RSI to decline. Since gains and losses will stabilize or even change direction, sooner or later, a proper RSI evaluation can aid in making the most profitable portfolio buying decisions.
Tips on Using the RSI
Use these tips and strategies when applying RSI calculations to your stock market selection strategies:
- Don't use the RSI on an absolute basis. Under the most optimal trading scenario, making any buy or sell decisions based solely on an RSI calculation isn't advisable. Often, external data or influencers (like a rumor of a CEO stepping down or a product recall) will hit the news and move stocks for reasons that have little to with the relative strength indicator.
- Know the difference between convergence and divergence. If your RSI calculation mirrors a security's performance trend, that's known as convergence. In contrast, is your RSI calculation goes against a security's performance trend, that's known as divergence. Divergence is especially important as it could mean an imminent share price reversal.
- Don't limit your timetable. Traders and investors usually use the RSI on a 14-period trading session basis, but there's no reason you can't shorten or lengthen your calculation timeframes, based on your unique portfolio needs. By and large, though, know that the shorter your timeframe, the more sensitive your calculation data readings, and the higher the odds of falling victim to inaccurate RSI calculations.