Because stock trading carries a measure of speculation, investors often depend on certain identifiers to help them analyze market trends so they can make informed investment decisions. As the values of stock securities rise and fall, the relative strength index helps investors track this movement, but it’s not merely a tracking tool. The RSI indicator ultimately pulls back the curtain to shed light on whether a specific stock security experiences more buying activity or selling activity over a certain trading period.
The RSI serves to help investors track how strongly stock prices rise and fall over a period of time. It's a useful tool to indicate whether stocks are overbought or oversold.
RSI Definition and Overview
Developed by J. Welles Wilder in 1978, the RSI is a graphic representation of market momentum data. As it applies to the stock market, this graph shows the averages of a stock security’s gains and losses, which are assigned values between zero and 100 as the gains and losses oscillate. The purpose of graphing this activity is to help investors identify stocks that are overbought or oversold.
What Are Oscillators?
In the study of physics, students learn that something that oscillates typically displays a certain regularity of movement around a fixed point. But stock market prices often display movement that is anything but regular, which is described as nontrending or choppy movement. Stock market oscillators are the indicators that allow an investor to view this nontrending movement on a chart or graph.
Stock Market Momentum
The stock market is not static; it has motion referred to as “momentum,” which describes the up-and-down movement of stock over time. RSI is a graphic representation of this momentum as a reflection of the rate of a stock security's rising and falling prices. And it’s this momentum that many stock investors find useful as an indicator of a specific security’s strength or weakness. A stock's value may change quickly, such as from hour to hour, which can certainly be graphed on an RSI chart, but it's more common for charting experts to graph the RSI on a daily basis.
Momentum Indicator Equation
Not surprisingly, values that are plotted on a graph typically have some math behind them. To calculate a stock security's momentum, the equation is actually a simple one: M = V - Vx, where M represents momentum, V represents the latest price of a particular stock, and Vx represents the closing price x number of days ago. Once you calculate a security's momentum by using this equation, you can determine the rise or fall of a stock's value over time.
RSI Indicator Equation
The RSI indicator calculation tweaks the standard momentum equation by bumping it up to a finer-tuned representation of a security’s movement. The standard momentum equation charts a stock’s movement based on price and time, but the RSI indicator equation also includes a security’s up closes and down closes. The equation to calculate RSI is: RSI = 100 – (100/1 + RS), where RS represents the average of a certain number of days’ up closes divided by the same number of days’ down closes.
Combining Momentum and RSI Indicators
Momentum indicators and RSI indicators are two of the many standalone tools that analyze stock market performance and trends. When you look at each momentum indicator separately, you’ll find a sound analysis of certain data.
But these two market indicators can also be used together for an even more comprehensive analysis of stock securities by using entry points and exit points. An entry point represents the price you pay for a stock security, and an exit point represents the amount you receive when you sell a stock security. By including the subtleties of entry and exit points, investors may be able to optimize their buying and selling habits.
Interpreting RSI Stock Results
As the RSI indicator is plotted on a graph from zero to 100, two of the key ranges to watch are the price movements above 70 and below 30. When the RSI is at 50, it indicates a neutral momentum for the stock price. But if the value moves above 70, the stock typically is considered overbought. And if the value moves below 30, the stock typically is considered oversold.
“Overbought” means a security is trading above its value, according to traders or analysts, and generally represents a recent or short-term occurrence. “Oversold” means a security is trading below its value, generally representing a short-term change in the stock’s price.
Some charts show 80 and 20 as the overbought and oversold thresholds instead of the 70/30 levels, but some experts consider the 20/80 values problematic. If investors rely on the 20 threshold, they may buy too late; if they rely on the 80 threshold, they may not sell at the optimal time.
Bull and Bear Market Characteristics
"Bull" and "bear" are descriptions of stock market price movements. Stock prices that follow an upward direction (prices are rising) are characteristic of a "bull" market, and stock prices that follow a downward direction (prices are falling) are characteristic of a "bear" market. In a bull market, investors typically see an RSI value between 40 and 90. In a bear market, investors typically see an RSI value between 10 and 60. These values can vary, depending on a particular security or market trend.
Stock Market Trends
Stock prices can move up, down or sideways over certain periods of time. This direction of movement is called a “trend.”
If you look at a stock security’s RSI on a chart or graph, you’ll see lines that move up and down as the collective points move in an overall linear direction. Over a given time period, and in a certain sideways range, the stock prices generally follow an upward or downward movement, which helps you visualize the security’s trends. Analyzing these trends by charting RSI is one way that investors find RSI a helpful tool in making their investment decisions.
“Trend trading” describes the practice of many investors who analyze stock market trends and invest accordingly. Although there is not one definitive indicator tool that trend traders use, RSI is one of the useful (and time-tested) tools in the toolkit of many trend traders.
Each market indicator vehicle differs slightly from other indicators, and the RSI indicator typically is used to identify overbought and oversold states as the impetus to sell or buy securities. For example, an investor may interpret a “buy signal” when she sees the RSI value dip below 50 and then rise above that same mark. But investors are cautioned that trend trading is not a guarantee of financial success, even though many analysts believe that it can tip the odds in your favor.
A stock’s RSI price chart compares the momentum of bullish and bearish movements within the market. Similar to other stock indicators, RSI is most reliable when it’s analyzed during a long-term trend. Otherwise, investors may come to a “false positive” or “false negative” conclusion. For example, a bearish crossover followed by a sudden price acceleration may give a false negative reading and, conversely, a bullish crossover followed by a sudden price deceleration may give a false positive reading.
Do Your Due Diligence
The U.S. Securities and Exchange Commission urges consumers to research companies that may be potential investments. Visit Investor.gov and perform a search for "stocks" to pull up a wealth of information about stocks, including the different types of stocks, the benefits and risks, understanding stock fees and how to buy and sell stocks. The SEC also provides a research tool so you can look up information about public companies before you purchase their stock. At Investor.gov, enter "EDGAR" in the search box to pull up the SEC's Electronic Data Gathering, Analysis and Retrieval database.
Video of the Day
- Investopedia: Exploring Oscillators and Indicators - RSI
- Investopedia: Overbought or Oversold? Using the RSI to Find Out
- Investopedia: Understanding Momentum Indicators and RSI
- Investopedia: An Introduction to Oscillators
- Investopedia: Entry Point
- Investopedia: Exit Point
- Investopedia; Overbought
- Investopedia: Oversold
- Investopedia: Digging Deeper Into Bull and Bear Markets
- Charles Schwab: The Trend is Your Friend - A Guide to Trading Trends
- Investopedia: Trend Trading - The 4 Most Common Indicators
- Investopedia: Relative Strength Index - RSI Definition
- Investor.gov: Stocks
- Investor.gov: Using EDGAR - Researching Public Companies