RSI is a popular momentum indicator used in technical analysis to help identify overbought or oversold conditions in a financial market. It measures the magnitude of recent price changes to evaluate overbought or oversold conditions.
How RSI Works:
The RSI calculates a value between 0 and 100, typically using a period of 14, which can be days, weeks, etc., depending on the chart.
- Determine the Average Gain and Average Loss over the last 14 periods.
- Calculate the RS (Relative Strength), which is the ratio of Average Gain to Average Loss.
- Calculate the RSI using the formula:
RSI = 100 - (100 / (1 + RS))
How to Use RSI:
- Overbought Condition: An RSI value above 70 typically indicates that a security may be overbought and could be due for a price pullback or correction.
- Oversold Condition: An RSI value below 30 often signifies that a security may be oversold, indicating it might be a good buying opportunity.
- Divergence: If the price is making new highs/lows, but RSI is not, it may indicate a reversal is near.
- Centerline Crossover: If RSI crosses above 50, it can be a bullish sign; if it crosses below 50, it can be a bearish sign.
Example:
Imagine a stock with the following 14-day data:
- Average Gain: $2
- Average Loss: $1
The RS would be 2 / 1 = 2, and the RSI would be calculated as:
RSI = 100 - (100 / (1 + 2)) ≈ 66.67
Since the RSI is above 70, this stock might be considered overbought, suggesting it could be time to sell.
Remember, while RSI can be a valuable tool, it's essential to use it in conjunction with other analyses and indicators. No single tool will provide a foolproof method for trading or investment decisions, so practicing with historical data or a demo account can help you understand how to use RSI effectively.