J. Welles Wilder is known for his innovations in technical analysis – like Average True Range, Average Directional Index (ADX) and the Parabolic SAR – but perhaps his most popular indicator used in trading is the Relative Strength Index.
The Relative Strength Index (RSI) is an oscillator that measures the momentum of price change. It uses a scale between zero and 100 and is considered “overbought” when over 70 and “oversold” when below 30. Like many technical analysis indicators, the RSI has a lookback period where it compares price changes for a specific period of time – this is typically set to 14.
To calculate the RSI, you take the average gains from the last n days and divide that by the average losses from the same n days. For instance:
RS = Average(Gains, nPeriod) / Average(Losses, nPeriod);
The result is then normalized to a 0 to 100 scale by doing:
RSI = 100 – (100 / (1+RS));
The original calculation uses a Simple Moving Average for the gains and losses, but some version will use the Exponential Moving Average. I have even seen the Hull Moving Average used for an extra smooth and responsive RSI movement.
The purpose of most oscillators is to show when a security is over extended to the upside or the downside. When the RSI is above 70 it is considered Overbought and when it is below 30 it is Oversold. And also like most oscillators, you cannot trust that when a security is Overbought or Oversold that it will change its trend any time soon – sometimes trends can last for weeks before price returns to the mean.
So what I use the RSI for? The RSI can tell you the strength of directional movement. Given the typical 14 day period, when the RSI pegs 100, it means there has not been a losing day in the last 14 days. Likewise, if the RSI hits 0 (zero) then there have been no gains in the last 14 days. Obviously those conditions cannot last forever, but given that the Overbought and Oversold zones are 30 points each, it is possible they can last a long while. But know that the steeper the directional move is in the RSI, the stronger the trend is in the market.
This is to say, use the RSI for directional momentum rather than a signal that the market is about to turn.