Relative Strength Index is used to measure the strength and speed of overbought or oversold items. It determines the quantity of selling or buying of an item. J. Welles Wilder Jr. introduced this indicator in his ground breaking 1978 book, “New Concepts in Technical Trading Systems. It provides signals for both buying and selling decisions. The RSI swings back and forth, like a swing at the playground, going from 0 to 100. When the score is 70 or more, it means too many people are playing (overbought). When it’s 30 or less, not many are playing (oversold).

Readings below 30 generally indicate oversold stock. Why?

This indicates that many people are selling, which could cause the price to shift or slow down its downward trend. Traders may view this as an opportunity to invest or place long-term bets.

Readings above 70 typically indicate overbought stock. Why?

This suggests that many people are making large purchases, which can cause the price to change direction or slow down. This could be interpreted by traders as a signal to sell or take profits.

How does RSI make its calculations?

The RSI (Relative Strength Index) is like a tool that helps us figure out if something, like a stock or a toy, is getting stronger or weaker in terms of its price. It looks at how the price has been changing recently.

Imagine you have a toy that’s been going up and down in price. The RSI checks if it’s been going up more than down over a certain period, like the past few days. If it has, it suggests that the toy is getting stronger, like it might keep going up in price. But if it’s been going down more than up, it suggests the toy is getting weaker, like it might slow down or even get cheaper.

So, the RSI helps us understand if something’s price is getting stronger or weaker by looking at how it’s been changing recently.

Mathematical RSI calculations

Step 1

We will take the closing price of the stock for a few days, say 6 days.     

Day 1. 29th Aug.	Day 2 30th Aug.	Day 3 31st Aug.	Day 4 1st Sept.	Day 5 2nd Sept.	Day 6 3rd Sept.	Day 7 4th Sept
5.88	5.84	5.61	5.63	5.68	5.40	5.41

We need the extra one column to help calculate the value for the 6th day.

Step 2:

We compare the closing price of the current day with the previous day’s closing price.

Day 1 29th Aug.	Day 2 30th Aug.	Day 3 31st Aug.	Day 4 1st Sept.	Day 5 2nd Sept.	Day 6 3rd Sept.	Day 7 4th Sept.
5.84-5.88	5.61-5.84	5.63-5.61	5.68-5.63	5.40-5.68	5.41-5.40	5.41

You can clearly see that the 7th column really did not count but it was still useful in the comparison of the closing price for day 6.

Step 3:

We note the gain and loss respectively.

Day 1 29th Aug.	Day 2 30th Aug.	Day 3 31st Aug.	Day 4 1st Sept.	Day 5 2nd Sept.	Day 6 3rd Sept.	Day 7 4th Sept.
-0.04	-0.23	0.02	0.05	-0.28	0.01	5.41

Take note that all other figures changed except for day 7, that’s to show that it’s no longer relevant at this point. All values with the negative sign in front indicate ‘loss’ while the positive values indicate ‘profit’.

Step 4:

We take an average of the gains (and losses) for a certain period.

Taking average is simply adding up the values for the 6 days and dividing the result by 6. i.e. To calculate our gain, we add up all positive values from the table, for the days which do have negative values, we represent with 0.00. I hope you understand to this point?

Calculating the loss is the same process as calculating for the gain. We add up the negative values and impute 0.00 to replace the positive values

Average gain= 0.00+0.00+0.02+0.05+0.00+0.01.           

                        ______________________________________________ =       0.08/6 = 0.013.

                                                              6       

Average loss= 0.04+0.23+0.00+0.00+0.28+0.00                  

                       _____________________________________________ =       0.55/6 = 0.092

                                                                        6                       

                                           

Take note that the average gain is less than the average loss for the period of 6 days.   

Step 5:

We calculate the relative strength “RS” which is simply, (Avg Gain)/(Avg Loss). Thus,RS = (Avg Gain)/(Avg Loss)

0.013

_______________________ = 0.14

   0.092

Step 6:

Now we calculate the RSI.

RSI = [100 – (100/{1+ RS})]

                 [100-(100/{1+0.14})]

                    [100-(100/1.14)]

                   [100-87.72]

                    = 12.28.

Advantages of Relative Strength Index

• RSI serves as a gauge of how rapidly traders are pushing a security’s price up or down.
• RSI assists traders in recognizing whether a stock has become overbought, indicating a rapid and potentially excessive price increase that may lead to a correction.
• RSI relies on a straightforward mathematical formula, making it accessible for manual calculations if needed, unlike some other complex technical indicators.
• RSI simplifies the process of chart analysis, providing a clear visual representation of potential price momentum shifts.
• It offers uncomplicated notifications that help traders identify trading opportunities based on overbought or oversold conditions.

Limitations of Relative Strength Index

Because the RSI may rise or fall for extended periods of time without a defined direction, producing confusing indications, it is not always reliable. For extended durations, the RSI might stay extremely high or extremely low. RSI may not be very helpful during strong market moves as a result. It operates most effectively when its signals coincide with the dominant long-term trend. Genuine signs of a trend change are uncommon and might be difficult to differentiate from false signals, such one that forecasts a price increase followed by a sharp decline.
                   

 Key Points

• Relative Strength Index is used to measure the strength and speed of overbought or oversold items.
• Reading below 30 indicates an abundance of selling pressure.
• Reading above 70 indicates that there has been an excessive buying pressure.
• RSI isn’t always reliable as it can fluctuate without a clear trend for a while.