The Relative Strength Index (RSI) is probably the most popular indicator. Why is it so widespread? Maybe because of how universally simple it actually is or maybe because it aims to provide clear buy and sell points.
That was indeed the intention of technical analyst Welles Wilder, who came up with it in 1978. He was a mechanical engineer and real estate developer but his research into markets and technical analysis led him to develop the RSI and five other indicators but the rest haven’t managed to gain such fame.
Here’s the formula used to calculate it:
RSI = 100 – 100 / (1+RS)
Here RS is equal to the average gain of up time periods (for the timeframe that the trader has chosen) divided by the average loss of the periods with a drop for the same timeframe.
Using this approach the RSI measures the strength of an instrument’s moves up and down. Its value can be between zero and 100 and its standard timeframe is 14 time periods (which can be hours, days, weeks, etc.) But it has to be noted that various approaches can use different timeframes.
Traders use the spikes above 70 and drops below 30 to find areas in which the price is in either overbought or oversold territory. You can see an example of those moves in the picture above.
The assumption is that a reversal in its direction is then likely to follow. In other words the RSI tries to measure the force behind moves and find where that force has lost its strength.
Wilder also thought that the RSI can be used to show reversals and even new trends through so called “divergences” (just like we did in this analysis of the NIKKEI index). A bearish divergence happens when the indicator can’t reach new highs and vice versa – bullish divergences are when new lows of the RSI aren’t reached despite a new low on the chart of the instrument.
The RSI is indeed the most popular indicator, but there are risks in using it and more experienced traders use it in tandem with other types of indicators which you can find in our previous article on technical indicators.