The relative strength index is an indicator of buying or selling opportunities for a security, such as. a stock or commodity..
Canva
What Is the Relative Strength Index?
The relative strength index (RSI) indicates whether a security, such as a stock, is overbought or oversold. It’s a technical indicator that is a part of a group of measures known as momentum oscillators, which determine whether a stock’s movement signals an opportunity to buy or sell. Another popular oscillator used by investors and analysts is the moving average.
Technical indicators, in the case of stock prices with RSI, have very little to do with a company’s fundamentals (earnings, revenue, etc.) and instead focus solely on stock price movement.
RSI can be used effectively on any security or commodity that has a price and is traded daily. It’s commonly used when markets are either in a downturn or upturn and are moving very quickly in either direction. Investors use the indicator on a stock that has been making sharp up or down moves in a short period and want to know from that technical analysis whether to buy or sell. Popular instruments and commodities to track via relative strength index include bitcoin and gold and silver.
Relative Strength Index = 100 – (100 / [1 + {14-Day Average Gain / 14-Day Average Loss} ] )
Relative Strength Index Formula
RSI = 100 – (100 / [1 + {14-Day Average Gain / 14-Day Average Loss} ] )
How to Calculate a Stock’s Relative Strength Index
The indicator uses 14 days as a benchmark, and that represents roughly three weeks of data, on the premise that trading is conducted only during weekdays (Monday to Friday). Some investors and analysts, though, use other periods, such as 20 or 30 days.
Over that 14-day period, determine the stock’s average gain in price on days when it rises from the previous day, and the average loss for days when it is down from the previous day. The relative strength is calculated by dividing the average gain by the average loss.
From there, input the data into the RSI formula above. The indicator must be between 0 and 100. If the RSI is lower than 30, it suggests the stock has fallen more than it should have (i.e., is oversold) and signals a buying opportunity. If it is higher than 70, this suggests that the stock has risen more than it should have (i.e., is overbought) and signals a selling opportunity.
In other words, if the stock is trending at 30 or lower, the indicator suggests a reversal for the price to go higher. The same applies for the stock trending at 70 or higher; this is an indication of reversal for the price to go lower. An RSI at around 50 suggests no immediate price action to move either up or down.
How to Calculate RSI on a Spreadsheet
Step 1: Gather data, at least 15 days’ worth of prices. In this example, the closing stock price of Netflix is collected over a 1-year period.
Step 2: Calculate daily percentage change. (Note: The formulas for each cell are shown in the top left field area of the screenshot of the spreadsheet.)
Step 3: Create separate columns for daily gains and losses. The cells for either gain or loss are highlighted in different colors, and this can be customized via conditional formatting. The loss column must be an absolute value.
Step 4: Calculate the 14-day average for gain and loss from the separate gain and loss columns, and list the 14-day average on the row of the 14th day of the average.
Step 5: Calculate relative strength by dividing the 14-day average gain by the 14-day average loss. (Note: If the number is negative, that means the data in the average loss column aren’t expressed in absolute value terms.)
Step 6: Calculate the relative strength index by inputting the relative strength data into the formula. As a new trading day rolls in, the RSI recalculates 14 days of data to include the latest closing price.
Step 7: Graph the data of the relative strength index.
How to Interpret the Relative Strength Index
In the graph above for Netflix, the 1-year data show that there were roughly five instances in which the stock was seen as oversold and indicated a reversal for the price to turn higher, and four times when the stock was viewed as overbought and indicated a reversal to go lower. Each of these cases shows a reversal in direction after prices broached one of the levels.
The RSI in data table format is sufficient to tell whether a security is oversold, overbought, or neither. But showing the data graphically provides opportunities to use other measures in interpreting relative strength.
If the RSI mimics the price movement of a security, it’s known as convergence. Conversely, divergence shows that a security is moving in the opposite direction of what the RSI indicates, and that could mean a reversal in price.
A head-and-shoulders pattern may form, and that would also indicate a reversal in the direction of price and whether to buy or sell. Within RSI, marking the peaks above 70 and troughs below 30 could provide trendlines on the direction of the security.
What Are the Limitations of the Relative Strength Index?
Technical indicators such as the relative strength index measure a stock price’s performance but have little to do with the fundamentals of a company. However, used with other measures or metrics such as the price-to-earnings ratio, RSI could be a complementary tool in investing and analyzing companies.
Frequently Asked Questions (FAQ)
The following are answers to some of the most common questions investors ask about the relative strength index.
Why Are 14 Days Used in the Relative Strength Index?
14 is the benchmark number of days, but some investors and analysts use other lengths of days such as 20 or 30.
Can Relative Strength Index Be Used in Fundamental Analysis?
RSI measures only a security’s price performance and doesn’t include fundamentals. However, despite it being used mainly in technical analysis, RSI can be a complementary tool when used with other measures in company analysis, or it can be used in trading strategies such as short selling.
