RSI Indicator Trading Strategy

The Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. This is a very technical look how the RSI operated with full mathematical equations. Recommended for advanced traders who want to understand the math behind it all.

Here’s How The RSI Indicator Trading Strategy Is Calculated

Calculate the Average Gain and Average Loss:

• First, determine the time period for which you want to calculate the RSI. Commonly used periods are 14 days (or periods for intraday trading).

Gain and Loss for Each Period:

• For each period, calculate the price change from the previous period to the current one.
  If the price change is positive, it’s considered a gain; if negative, it’s a loss. Absolute values for losses are not used here; we’re interested in the magnitude of the change.

Initial Average Gain and Loss:

• Sum up all the gains over the first 14 periods and divide by 14 to get the initial average gain.
  Similarly, sum all the losses over the first 14 periods and divide by 14 for the initial average loss.

Subsequent Periods:

• After the initial calculation, for each new period.

Update the average gain using this formula:

New Average Gain
=
(
Previous Average Gain
×
13
+
Current Gain
)
/
14
Update the average loss similarly:
New Average Loss
=
(
Previous Average Loss
×
13
+
Current Loss
)
/
14
Calculate the Relative Strength (RS):
RS is the ratio of average gain to average loss:
RS
=
Average Gain
Average Loss
Calculate the RSI:
Using the RS, compute the RSI with this formula:
RSI
=
100
−
100
1
+
RS

Here’s a step-by-step example

Suppose over the last 14 days, you have:

• Total Gains = 20 points
• Total Losses = 10 points
• Initial Calculations:
• Average Gain = 20 / 14 = 1.43
• Average Loss = 10 / 14 = 0.71
• RS = 1.43 / 0.71 ≈ 2.01
• RSI = 100 – (100 / (1 + 2.01)) ≈ 66.77

This process continues with each new price movement, updating the averages for gain and loss based on the most recent data point. Keep in mind:

Zero Division

If there’s no loss over the period, to avoid division by zero, you might use a very small number for the loss or handle this case specifically in your calculation.

Interpretation:

1. RSI values above 70 are typically considered overbought, and below 30 as oversold. However, these levels can be adjusted based on the specific asset or market conditions.
2. This method provides traders with an indicator to gauge the momentum of recent price changes, which can be critical for making trading decisions in options trading.
3. The Relative Strength Index (RSI) is a versatile momentum oscillator that traders use for several key interpretations in the context of technical analysis.

Here’s how to interpret RSI values:

Basic Interpretations

Overbought Condition:

• An RSI value above 70 is generally considered an indication that an asset might be overbought. This suggests that the recent price increases might have gone too far too quickly, potentially leading to a price correction or reversal. Traders might look for selling opportunities or might expect a pullback in price.

Oversold Condition:

• Conversely, an RSI below 30 indicates an oversold condition. This suggests that the asset might have been sold off too heavily, and a price rebound could be imminent. This might be seen as a buying opportunity by traders expecting the price to recover.

Advanced Interpretations

Divergence

Bullish Divergence:

• Occurs when the price makes a lower low, but the RSI forms a higher low. This can signal that the downward momentum is weakening, and a price reversal to the upside might be forthcoming.

Bearish Divergence:

• Happens when the price hits a higher high, but the RSI shows a lower high. This might indicate that the upward momentum is fading, and a price drop could follow.

Failure Swings:

• These are independent of price action and occur when the RSI itself shows a pattern of higher lows followed by a lower high (bearish failure swing) or lower highs followed by a higher low (bullish failure swing). These patterns can signal potential trend reversals before they appear in the price.

Trend Confirmation:

• RSI can confirm the strength of a trend. In a strong uptrend, RSI might spend more time above 50, while in a downtrend, it might remain below 50. This doesn’t necessarily mean the asset is overbought or oversold but rather that the trend is robust.

Centerline Crossovers:

• Moving above 50 can be seen as bullish, while dropping below can be viewed as bearish, although these signals are less potent than overbought/oversold conditions unless combined with other indicators or patterns.

RSI Considerations:

Adjusting Levels:

• In volatile markets or for different assets, the traditional 70/30 thresholds might not be optimal. Some traders adjust these levels to, for example, 80/20 for very volatile stocks or assets.

Time Frame:

• The interpretation of RSI can differ based on the time frame analyzed. What appears as an overbought signal on a 5-minute chart might not hold true on a daily chart.

Confirmation:

• It’s crucial not to rely solely on RSI for trading decisions. Combining RSI with other indicators, like moving averages or volume, can provide a more comprehensive trading signal.

Market Context:

• The effectiveness of RSI interpretations can vary with market conditions. In a strong bull market, assets might remain overbought for extended periods, and in bear markets, they might stay oversold.

Remember, while RSI is a powerful tool, its signals should be part of a broader trading strategy that includes risk management and other forms of analysis to mitigate false signals and enhance decision-making. See this post about RSI trading scenarios to learn more.