Indicator insight: Relative Strength Index

The relative strength index (RSI) is a momentum oscillator designed to identify short-term momentum extremes (so-called “overbought” and “oversold” points). J. Welles Wilder, developer of the RSI, provides step-bystep instructions for calculating and interpreting the indicator in his book, New Concepts in Technical Trading Systems (Trend Research, 1978). Wilder described the indicator in terms of daily price bars, but the RSI can be used on any time frame.

The relative strength index should not be confused with the concept of relative strength, which is a comparison of the price action of one instrument to another — most commonly, an individual stock to its group, sector, or the overall market. Other well-known indicators similar to the RSI include stochastics, momentum and rate of change, and the Commodity Channel Index (CCI).


Calculation

The basic RSI calculation is a ratio of the average up closes (those bars that closed higher than the previous close) to the average down closes (those bars that closed lower than the previous close) over a certain period. The ratio is then normalized to have a range of values between 0 and 100 using the following formula:

RSI = 100 – (100/[1+(U/D)])
where

U is the average of the up closes over a given period;

D is the average of the down closes over a given period.

For example, to start the calculation of a 10-day RSI, the close-to-close price changes of all the up closes over the most recent 10 days would be summed and divided by 10, resulting in U in the formula. Similarly, the close-to-close price changes of all the down closes over the most recent 10 days would be summed and divided by 10, resulting in D. (Wilder actually used a modified exponential smoothing calculation to simplify calculation from day to day.) The RSI measures price momentum by measuring the strength of up days (or bars) to the weakness of down days (or bars) over a given period. If there are more (or larger) up days than down days over a given period, the RSI will rise; if there are more (or larger) down days than up days, the indicator will fall.

Wilder’s default “look-back” period for the RSI is 14 days, although no time period is better than any other — it depends on the market conditions and the trader’s time frame. The fewer days or bars used to calculate the indicator, the more sensitive it will be to shorter-term price fluctuations.