What is the RSI indicator and how can it be used to build consistently profitable trading strategies?

This 3-part series on the RSI will teach you everything you need to know about this popular trading indicator.

Here are the 3 parts to this series:

  1. RSI Indicator Explained: Calculation and Definition
  2. RSI Trading Strategies: How to Trade the RSI
  3. RSI Strategies Tested: Do They Really Work?

In this post, I’ll explain the RSI indicator, I’ll show you how it’s calculated, and give you its strengths and weaknesses.

What is RSI?

RSI is the abbreviation for Relative Strength Index. It was first introduced by J. Welles Wilder in his 1978 book, New Concepts in Technical Trading Systems.

It’s basically an indicator that can help traders identify potential reversal points in a market.

The theory behind the RSI is that buyers and sellers can usually only push the market in one direction for so long. This leads to so-called “overbought” or “oversold” conditions.

Eventually, the price momentum will run out and the market will have to move in the opposite direction…at least for a little while.

That’s when countertrend traders can potentially step in and make some money with the RSI indicator.

Here’s what the RSI looks like on a chart:

RSI Indicator Explained: Calculation And Definition

The default settings for the RSI are usually:

  • 14 period look back
  • 30 is oversold
  • 70 is overbought

Now let’s take a closer look at the RSI…

RSI Calculation Formula

The way that RSI is explained in most books and on most websites is a little confusing.

So we created a graphic that clears up the confusion and shows you exactly how the RSI calculation formula works.

RSI Formula Calculation - RSI Indicator Explained: Calculation And Definition

Alright, now that you know the formula, let’s break down each component…

First, let’s start with the variables.

Number of Periods (n) or Length

RSI period setting - RSI Indicator Explained: Calculation And Definition

n is one of the settings that you would use in charting platforms like TradingView or MetaTrader.

It’s basically the number of periods that you want to look back on the chart to determine the current RSI value.

The default value is usually 14 periods, but it can be changed, according to your needs.

When the RSI is set to 14, your charting software will calculate the current RSI value based on the last 14 periods.

Many websites refer to the default RSI setting as 14 days, but that’s only if you are trading on the daily chart. The RSI look back can also be measured in weeks, hours or minutes. 

It just depends on what timeframe chart you are using the indicator on.

Therefore, I will refer to the RSI look back setting in periods, which is more accurate.

Your RSI period setting will depend on your goals and your trading strategy. There’s no right or wrong answer here.

It just depends on what you have tested and what is profitable for you.

You will learn more about how the RSI settings affect the characteristics of a RSI trading strategy in parts 2 and 3 of this series.

Relative Strength (RS) First Data Point

First data point - RSI Indicator Explained: Calculation And Definition

The raw Relative Strength number simply shows you how current price compares to historical prices over the last n periods.

It can be a little tough to understand what that number is actually telling you. So Wilder’s formula turns the number into an index that stays between zero and 100.

Therefore, the RSI is an oscillator because it goes back and forth on a fixed scale between 0 and 100. Having a set scale allows RSI to be easily used across any trading instrument.

It’s also a momentum indicator because its goal is to show traders when momentum could be slowing down.

First RSI point - RSI Indicator Explained: Calculation And Definition

The first RSI graph point is calculated by summing the up periods and dividing the result by the n periods setting in the RSI indicator.

That number is then divided by the average of the down periods over the last n periods.

For example, let’s say that you are trading the daily chart and n is set to 5. The last 5 days are as follows:

  1. 10 pips up
  2. 20 pips down
  3. 100 pips up
  4. 30 pips down
  5. 200 pips up

In order to calculate the numerator, you would average the up days:

10 + 100 + 200 = 310 / 5 = 62

Then you would calculate the denominator with the down days:

20 + 30 = 50 / 5 = 10

Finally, you would divide the numbers to get:

62 / 10 = 6.2

Therefore…

RS = 6.2

Converting RS into RSI

From there, you would turn RS into RSI by doing the following…

RSI calculation - RSI Indicator Explained: Calculation And Definition

So starting from the right side of the equation:

100 / (1+ 6.2) = 13.8

Then…

100 – 13.8 = 86.2

Which means…

RSI = 86.2 

Subsequent RS Calculations

After the first RSI data point, all of the following data points are calculated with this modified formula.

RSI second data point - RSI Indicator Explained: Calculation And Definition

This formula is similar to an exponential or weighted moving average, in that it gives more weight (importance) to the current RS reading.

So you would start by averaging the first n-1 periods for both up and down moves. Then you would add in the current average for up and down moves to their respective averages and divide each total by n.

Let’s use the data from the previous example and add in a 6th period, to show you how this works.

  1. 10 pips up
  2. 20 pips down
  3. 100 pips up
  4. 30 pips down
  5. 200 pips up
  6. 30 pips down

First, you would average the first 5 (n-1) up periods.

100 + 200 = 300 / 5 = 60

Then you would multiply the average by n-1 or 5.

60 * 5 = 300

Now we do the same for the denominator.

20 + 30 = 50 / 5 = 10

10 * 5 = 50

Next, average the data from the previous 5 periods, plus the 6th period. Since the 6th period is a down period, nothing would be added to the up periods calculation.

300 + 0 = 300 / 6 = 50

Add in the 6th period down move, then average by 6.

20 + 30 + 30 = 80 / 6 = 13.3

Then RS is…

50 / 13.3 = 3.75

RS = 3.75

Converting RS into RSI

Again, we do the RSI calculation to convert the RS to RSI:

RSI calculation - RSI Indicator Explained: Calculation And Definition

100 / (1+3.75) = 21

100 – 21 = 79

RSI = 79 

RSI Signal Levels

As mentioned above, the default signal levels are usually 30 and 70. But some traders will use 20 and 80.

This is where to find the signal levels on a chart.

EURCAD levels - RSI Indicator Explained: Calculation And Definition

If the RSI is over 70, price is considered overbought and is a potential sell signal. If the RSI goes below 30, that’s a potential buy.

The concept is simple, but it takes testing and practice to master.

We will get into RSI trading strategy details in part 2 of this series, but that’s the general concept of what the RSI tells you.

RSI Strengths

  • Since most markets usually trade in ranges, the RSI can be a good tool for taking advantage of reversal moves within a range
  • The calculation is easy to understand
  • This indicator is widely available

RSI Weaknesses

  • The RSI indicator does not do well in trending markets
  • An overbought or oversold signal does not guarantee that the market will reverse
  • Like any other indicator or trading strategy, it takes time to master

Where to Get the RSI Indicator

The RSI is available on most charting platforms.

In fact, all of the charting platforms I’ve used had the RSI.

I would recommend using the RSI on TradingView, but use whatever charting software works for you.

Common RSI Misconceptions

A few websites will tell you that a longer look back period is more “accurate.”

This is simply not true.

A shorter look back period will make the RSI more sensitive, which can work well for certain trading strategies. A longer period may work better for other strategies.

Test your strategy with different RSI settings and find out what really works for you. Never take anyone’s word at face value, always test it for yourself.

Other people on the internet will tell you that the RSI is a lagging indicator, so it’s not useful.

Professional traders use the RSI. This guy uses the RSI to trade for a living.

Get a MT4 indicator that gives you RSI alerts here.

An indicator is just another tool that you can use to spot trading opportunities. Some tools will make sense to you and others won’t.

Again, find what works for you. The RSI may not be an indicator for you.

I’ll give you an analogy…

In order to chop down a tree, some people might prefer to use a chainsaw, others might like to use an axe and still others might want to use a 2-person crosscut saw.

They all achieve the same end result…a tree gets chopped down.

Just in slightly different ways.

The same thing goes for trading indicators. They all look to make profits, but by using different methods.

Final Thoughts on the RSI Indicator

So that’s how to RSI works, how to calculate it and what it can tell you about a market.

This indicator is not for everyone, but if you like the idea of trading reversal moves, you should certainly look into it.

In the next part of this series, we will look at RSI trading strategies. I’ll show you 3 ways the RSI is commonly used to trade and I’ll give you 2 complete RSI trading plans.

Then in part 3, I’ll show you my actual backtesting results for each of the trading plans. This will give you a good idea of what works in RSI trading and is a good starting point for developing your own RSI trading strategies.

Stay tuned!

Still have questions about the RSI indicator? Leave your question in the comments below…

 

 

 

Disclaimer: Some links on this page are affiliate links. We do make a commission if you purchase through these links, but it does not cost you anything extra and we only promote products and services that we personally use and wholeheartedly believe in. A portion of the proceeds are donated to my charity partners. 





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RSI Indicator Explained: Calculation And Definition
RSI Indicator Explained: Calculation And Definition
RSI Indicator Explained: Calculation And Definition

RSI Indicator Explained: Calculation And Definition

RSI Indicator Explained: Calculation And Definition