The Relative Strength Index (RSI) is a popular technical indicator used by traders to evaluate the momentum and potential overbought or oversold conditions of a financial asset. Based on a 14-day timeframe, RSI compares the average size of recent gains to recent losses, resulting in a value between 0 and 100.
An RSI reading over 70 indicates the asset may be overbought, signalling the price could reverse lower from overvalued levels. On the flip side, an RSI below 30 suggests the asset is oversold and could see a bounce higher.
RSI In Action
In the following chart, you will see that the forex pair EURUSD was indicated as being overbought (highlighted in green) when the price reached $1.1250, giving a signal that the price may soon reverse. Shortly thereafter, the price did just that – it reversed.
RSI has two main applications – spotting trend reversals and gauging trend strength. Regarding reversals, overbought RSI levels point to potential selling opportunities if the price is deemed unsustainably high. Meanwhile, oversold readings signal buying opportunities if the price seems undervalued and poised to recover.
Additionally, RSI can confirm ongoing trend strength. In an uptrend, RSI remaining above 50 shows strong bullish momentum as buying pressure exceeds selling pressure. In downtrends, RSI staying under 50 reveals robust bearish momentum driven by dominant selling pressure.
However, RSI has limitations. It may remain overextended during strong trends, making timing entries difficult. Certain assets can also exhibit persistently overbought or oversold RSI conditions, leading to false signals. Using RSI together with other indicators like moving averages and analysing fundamentals provides more robust signals.
The History Of RSI
The Relative Strength Index (RSI) was developed in 1978 by the American technical analyst J. Welles Wilder Jr. An engineer by training, Wilder had a strong mathematics and mechanical background that he applied to the financial markets.
In the 1970s, technical analysis was gaining popularity amongst traders but lacked concrete rules and tools. Wilder sought to bring more analytical rigour to chart analysis through his books. His 1978 publication New Concepts in Technical Trading Systems↗︎ introduced several new technical indicators, with the Relative Strength Index being one of his most notable contributions.
The RSI provided traders with a numerical measure of price momentum and insights into overbought/oversold levels in markets. Wilder’s work established him as a pioneering figure in the advancement of modern technical analysis. Within a few years of its introduction, the RSI became a widely used indicator and remains a staple trading tool today.
