Relative Strength Index RSI – What Is Behind This Indicator

RSI, often heard, but no idea what is behind it? Then read our introductory article on one of the most classic indicators.

The Relative Strength Index (short: RSI) is another indicator from the pen of W. Wilder and is one of the standard indicators in every charting tool today, along with many others. The naming of the indicator was somewhat unfortunate, as it suggests a comparison of different underlyings with each other in order to find out which of the values is the outperformer and which the underperformer. But such a statement is not possible with the RSI according to Wilder. Rather, it is a further momentum concept within for just one single underlying. It simply compares the magnitude of price losses in the period set by the trader with the magnitude of gains in that period. In this sense, the RSI rather reflects the inner strength of the underlying instrument under consideration and also attempts to eliminate some negative aspects of the classic momentum indicator. On the one hand, the latter is relatively susceptible to individual price extremes and, on the other, has an open scale. This makes comparisons between the momentum values of different underlyings particularly difficult, and Wilder found a momentum indicator in the form of the RSI that could eliminate these problems.

Calculation of the RSI

As is so often the case with indicators, various further developments of the original indicators have emerged over time, mostly with the aim of eliminating one or the other disadvantage. This also applies to the RSI as such. At this point, one of the standard variants is presented, in which the trader must first select the period to be considered. 14 candlesticks are preset in Guidants. If we remain on a daily chart, the following calculation applies: Within the preset period, two sums are formed. Sum 1 contains all price changes of days with a rising closing price, while sum 2 contains all days on which the closing price was below the previous day. In the second step, both totals are smoothed by averaging over the preset period. If the period length is 14, both totals are divided by 14. The last step is now to determine the RSI. To do this, the average sum of the positive days is set in relation to the total average sum:

with: AvgSU = average sum of positive days (candles)

AvgSD = average sum of negative days (candles)

This last step fixes the RSI indicator to a value range between 0 and 100, which also gives it an oscillating character. In addition, the value range is classically divided into three parts: values between 0 and 30 are considered oversold, values between 30 and 70 are normal and values between 70 and 100 are considered overbought. If the price reaches one of the extreme ranges, Guidants color the area below it. Figure 1 shows us the RSI indicator in its default setting of 14 periods in the DAX daily chart.

Application and interpretation

As a classic momentum indicator, it is more than obvious to apply the typical interpretation possibilities for this group of indicators to the RSI as well, which would be there: Divergence analysis, analysis of the extreme states, intersections of indicator and various auxiliary lines and the classical formation analysis.

Within divergence analysis, the focus is on divergent movements between the RSI and the trend in the underlying. Starting from an upward movement in the underlying asset, we speak of a bearish divergence when the underlying asset together with the RSI enters a correction after a high point 1 and this is followed by a new buy wave in the underlying asset. However, while the underlying asset climbs to a new high, the RSI can no longer reach such a high. Figure 2 shows a bearish divergence schematically, while Figure 3 shows one in the Adidas share.

Similarly, a bullish divergence means that new lows in the Underlying are no longer confirmed by the indicator (see Figure 4, bullish divergence in the BASF weekly chart).

The basic assumption behind divergences is that the occurrence of such a bullish divergence represents a weakness in the current movement and can lead to a short-term change of mood in the market.

As with all divergence analysis, there is a lot to watch out for in terms of the RSI. First of all, it should be noted that only the closing price of a candle is included in the RSI and accordingly, highs and lows within a candle are also irrelevant in the divergence analysis. In addition, a trader always goes against the current trend in the divergence analysis, which is not without risk. Waiting for divergences through correspondingly confirming signals such as reversal patterns in smaller time levels of the underlying instrument or similar can increase the chances of success. In addition, divergences can drag on for a long time until the final change of mood, and not every trend reversal is accompanied by a divergence formation.

Another simple way of generating signals with the help of the RSI is to analyse the extreme conditions. If the RSI rises into the zone above 70, there is an overbought market/overstretched uptrend. The risks of an at least temporary correction increase. The return from the extreme zone could now be interpreted as a correspondingly confirming signal. The same applies to the opposite side. A plunge into the value range below 30 suggests an oversold market/overstretched downtrend and the chances of a recovery increase. If the RSI now breaches the threshold at 30 from below, a buy-signal is given. The trader himself can experiment with the thresholds in order to find a good setting for the underlyings he is looking at. This will be necessary, as well as the setting of suitable stops, because a look at the course of the RSI indicator shows that it can be quite “fidgety” around the thresholds. In Figure 5, the already known course in BASF from Figure 4 is used again for signal generation from the extreme zones, since here we can see quite nice signals. But that even with this signal logic not all that glitters is gold becomes obvious already with the first failed sell-signal.

Another possibility of interpretation or signal derivation would be to provide the RSI with a trigger line. In Figure 6, a simple moving average was used for this purpose, which was applied to the RSI.

This results in new crossing points that can be used for buy and sell signals, at least theoretically. However, as the chart already suggests, this application also requires additional filters, since the RSI is very volatile and crossings occur regularly without any decisive directional changes in the underlying asset subsequently occurring. At the same time, however, this approach also offers another approach. Smoothing over a moving average leads to a smoother RSI curve, which may have a positive effect on the signal logic already discussed. For example, new signals could be derived from the intersection of two averages applied to the RSI (see Figure 7) or the smoothing itself could be used to perform the extreme zone analysis already discussed (see Figure 8).

Finally, a brief reference should be made to the formation analysis in the RSI. In this sense, the RSI is interpreted as a price trend and the trader can look for corresponding chart patterns such as double lows, trend reversals, SKS formations and others. The use of trend lines, supports & resistances is also possible at this point.

Critical appraisal

The Relative Strength Index is one of the classic standard indicators in any charting tool, but this does not automatically make it a non-plus ultra weapon for traders and investors. I am relatively certain that the RSI can also be used for successful trading, but that additional filters are needed for this. This is not only shown by the examples shown in this article, but already results from a simple consideration. The RSI is clearly predictable as an indicator and with the help of today’s advanced analysis & trading techniques, which are available even to private traders, it would be too easy to trade highly profitable from a simple overlap of the RSI with its extreme zones or any averages. After all, anyone could do that, but the stock market is certainly not a place that makes everyone a winner. When using the RSI, whether as an analytical tool or for direct signal generation, one is encouraged to combine it with other elements of trading. Then the RSI will be able to make a valuable contribution. To name but one thing: your signals can be as good as you want them to be if you do not trade systematically and disciplined. Money management is the keyword here which you should never let fall under the table despite all the analysis (here you will find a really great guide to the topic of money management). Apart from that, a little bit of self-advertising at the end. At, I run my own trading service, which is aimed directly at beginners. In the training and seminar package I accompany you on the way to sustainable stock market success. You can find more information here. I would be pleased to welcome you there personally.

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