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Thursday, February 3, 2011

What is the Relative Strength Index (RSI)

The Relative Strength Indicator (RSI) was developed in 1978 by an individual named Welles Wilder. The RSI is what day traders call a 'technical indicator' and is a mathematical calculation used in the assessment of a securities performance. The RSI can be applied to stocks, currency, commodities and even baseball batting averages but the indicator was designed primarily for financial markets.

The relative strength indicators measures price momentum
Price momentum indicators help traders conform buy or sell signals

What the Relative Strength Indicator measures


The RSI measures short-term strength of price momentum as compared to recent price declines on a scale from 0-100. In other words, the indicator measures a financial vehicle's gain in proportion to recent losses over a period of 1-3 weeks. This allows day traders and brokerage firms to have a better idea regarding the significance of a price movement. The closer the RSI is to 100, the more significant the price increase is and the closer the RSI value is to 0, the greater the scale of price decreases. RSI values over 50 are considered 'bullish' or favorable while a value of 70 may indicate a financial instrument has been overbought.

How the Relative Strength Indicator is Calculated


Modern technology and computerized software programs often calculate technical indicators such as RSI for the trader so they don't have to waste their time with multiple equations. What's more the RSI's of securities can be displayed in the form of a graph allowing a trader to see how the RSI has changed over time. For this reason it can be considered more important to know what the RSI measures than how it is measured. However, for purpose of explanation the basic RSI calculation is as follows:

RSI= 100-(100/1+RS) where RS=(Total gains/n)/(Total losses/n) where n=number of days or periods.
This is one of the easier ways to calculate RSI as there is also a more sophisticated way to calculate it using past RSI's for greater accuracy or 'smoothing'. Also, if a securities price does not change from day to day the equation is adjusted to incorporate an 'exponential moving average'.

Usefulness of the Relative Strength Indicator


The usefulness of the RSI is relative to many external factors and other technical indicators. While it is not the only indicator, it is thought of as a useful one but is often not the only indicator used by traders when making buy or sell decisions. The reason the RSI is useful is because it is a reflection of enthusiasm for a particular stock, commodity or other financial instrument. When enthusiasm is high and a stock is not 'overbought' as indicated by the RSI, it may be a significant entry point for a trader.

In summary, the Relative Strength Indicator (RSI) is a mathematical metric used in technical analysis of financial instruments. The RSI is often calculated using financial software to assist traders in making buy and/or sell decisions. The RSI is one of many tools available to securities traders and measures price movement momentum. As useful as the RSI may be it is often used in conjunction with other technical indicators.

Sources:

1. http://tinyurl.com/2c5gdo
2. http://tinyurl.com/4edhgzm
3. http://www.investopedia.com/terms/r/rsi.asp
4. http://en.wikipedia.org/wiki/Relative_strength_index
5. http://invest-faq.com/articles/tech-an-rsi.html

 Source: 'Tradermatt' US-PD