Teaching the RSI

The relative strength index (RSI) is best known for identifying short-term overbought and oversold levels, but it has some uses that go beyond the textbook explanations of this indicator’s role.

The RSI’s calculation is similar to that of other oscillators. The indicator measures the difference between closing prices over a given period (say, 10 days) and compares the sum of the day-to-day gains to the sum of the day-to-day losses (see Indicator Basics for more detail).

Whenever an indicator calculates the difference between or divides two prices over time, it mathematically “detrends” the data — that is, it removes or minimizes the trend influence that may exist from time periods longer than the indicator’s look-back period.

This detrending process creates an indicator that fluctuates above and below a horizontal midpoint or “equilibrium” line (such as zero or one) that represents the price trend; the indicator may also be bounded by absolute upper and lower limits (e.g., zero and 100, or -100 and +100).

The RSI’s default look-back period is 14 bars. It is a 60-minute chart of the Euro/U.S. dollar currency pair (EUR/USD) with a 14-bar RSI and a 28-bar exponential moving average (EMA). Notice that whenever the RSI crosses its midpoint of 50 (points A, B, C, and D) price also crosses the 28-bar EMA. The 14-bar RSI is, in fact, the equivalent of the market price relative to a 28-period EMA bounded by zero and 100. This implies a function of the RSI that is often overlooked in textbook explanations of the indicator’s standard uses.