Relative Strength Index (RSI) is a technical analysis tool that is used by investors to make investment decisions. Developed by J. Welles Wilder, RSI is a momentum oscillator that helps in determining the rate of change of prices. RSI values range from 0 to 100. An RSI of 30 indicates that the asset is oversold while an RSI greater than 70 shows that the asset is in overbought position.
Investors generally look for divergences in the market prices which they can exploit to make profits. RSI helps in achieving this task. The tool can also be used to identify general price trends, centerline crossovers, and failure swings. This information can prove useful for investors in making wise investment choices.
RSI can be calculated using the formula given below.
RSI = 100 - 100 / (1 + RS)
RS = Average of up closes during a specific period / Average of down closes during a specific period
RSI technical analysis tool compares the average price increases and average price decreases to determine position of the asset. This RSI is calculated for different periods including 5 days, 10 days, 14 days and more.
If the RSI of an asset is more than 70 (overbought), investors avoid buying the asset, and try to sell the asset if they already own one. On the other hand, if the asset's RSI is below 30 (oversold), investors buy the asset, and hold the asset if they already own one.
An overbought asset means that too many investors have bought the specific asset at a particular time. As a result the prices are likely to fall in the near future. On the contrary, an oversold asset is likely to increase in value in the near term as investors will likely purchase the asset at a bargain price.
The default period of calculating RSI values is 14 periods. However, investors can increase or decrease the number of periods for determining RSI values. Higher periods decrease the sensitivity of the RSI values to actual market prices while lower periods increase the sensitivity. The actual period that is selected for calculating depends on the type of assets. A 14 period RSI for a utility company, for instance, is less likely to become oversold or overbought than a retailer such as Amazon. Investors can adjust the periods based on the requirements of the security.
Apart from type of security, the investment horizon also determines the RSI period selected by the investor. Short term traders generally use 2-period RSI, while long term traders use 30 or more period RSI to make investment decisions.
Like many other technical analysis tools, RSI offers the best benefits when used along with other complementary tools such as Moving Averages (MA), Moving Average Convergence Divergence (MACD), Fibonacci Retracement, and Support and Resistance Levels.
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