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The Relative Strength Index was originally developed by J. Welles Wilder Jr. It is a technical analysis momentum indicator used by traders to measure the magnitude of recent price changes to monitor overbought or oversold conditions in an asset or stock price. It moves as an oscillator between the values of 0 to 100.
Interpretation and Usage
RSI reading of 70 or above signals that a security is becoming overbought or overvalued and may be due to a trend reversal in price. Reading above 80 in extreme cases could be termed overbought. This is a selling opportunity. An RSI reading of 30 or below is a signal that a security price is oversold or undervalued.
Figure 1: the RSI denoting the overbought and the oversold region
The Relative Strength Index Formula
The RSI can be calculated using the formula below
RSI = 100 – (100/1+RS)
Where RS (relative straight ratio) = The Average gain divided by the Average Loss
Note that currency pairs can remain overbought or oversold for a long period of time, this implies that RSI alone is not always a great timing tool.
The RSI can stay overstretched for an extended period in a trending market. Therefore, in the up days when the trend is strong, positive trading days are sustained and the RSI remains supported on a move above 70 reading.
- This simply implies that, in a massive uptrend market, the RSI sustains a position above 70 in a long time.
- On the other hand, in a massive down-trend market, the RSI sustains a position below 30 in a long time.
That being the case, to be a profitable trader you have to trade with the RSI in the direction of the trend.