What is the Relative Strength Index (RSI)?
The Relative Strength Index (RSI) is a comparison between the days that the contract finishes up against the days it finishes down. This indicator is a big tool in momentum trading as it can help indicate the strength of a commodity to traders.
How the Relative Strength Index is Calculated
The RSI is calculated using the following formula:
RSI = 100 – 100 / (1 + RS)
RS= Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame
RSI values range from 0 to 100 and the standard time frame to compare up and down periods is 14 trading days.
What is RSI in Trading?
Traditionally, using RSI in trading a commodity price is considered overbought around the 70 level and you should consider selling. This number is not written in stone, in a bull market some believe that 80 is a better level to indicate an overbought price since prices often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30 price it is considered oversold and you should consider buying. Again, make the adjustment to 20 in a bear market.
The shorter number of days used the more volatile the relative strength index is and the more often it will hit extremes. A longer term RSI is more rolling, fluctuating a lot less. Different commodities and futures contracts have varying threshold levels when it comes to the RSI. Prices in some futures contracts will go as high as 75-80 before dropping back and others have a tough time breaking past 70.
When using RSI in trading a trader should beware of surges or sudden movements, as they can create exaggerated RSI numbers and show a false buy or false sell. Due to this, RSI should be used as a compliment to other indicator. The relative strength index can often be used effectively when couple with trendlines because the two often show correlating values.