With the increasing timely improvements in Forex technical analysis tools, the year 1978 saw a new oscillating indicator “Relative Strength Index (RSI)” introduced by J. Welles Wilder. The Relative Strength Index (RSI) is a very famous momentum indicator. This indicator is often confused with other common names “Relative Strength” rankings or “Relative Strength” charts. Unlike other types of “Relative Strength” indicators, the RSI uses one currency for calculating the value.
The RSI computes the value of the indicator by comparing the scale of a currency’s recent profits to the scale of its losses. This computed value can range between 0-100. RSI considers a single factor, which is the time period. J. Welles Wilder proposes the use of 14 such time periods. Lets look at how RSI is being calculated. The formula to calculate the RSI is given below
Given a data, RSI first sums up the amount for all previous gains or losses respectively. This data is usually taken for standard 14 time periods as suggested by Wilder. If the cases are more or less than 14, the calculation value is changed accordingly. RSI is a running calculation indicator, so the accuracy degree depends on how much old are the time periods used in the calculation. The “First Average Gain” is an estimated value, which helps to get the later values accurate. Therefore, one must have such 14 estimated values already calculated in hand. Thus “First Average Gain” is the total value of 14 such time periods divided by 14. The calculation for “First Average Loss” too goes in the same way, except for replacing the gains with the figures of losses.
The next step in this running calculation is computing next average gain / loss values with the help of previous values. This is done by multiplying the previous average gain / loss value by 13 and then adding the present average gain / loss value. Dividing the result as calculated, by 14, derives the final output. This is also termed as “smoothing” of the value.
The “RELATIVE STRENGTH” is calculated by dividing “Average Gain” by “Average Loss” for each time period.
The computation of RSI (Relative Strength Index) is then calculated by conversion of the RS value into an oscillator, which ranges between 0-100. The formula for the same is given above.
The RSI increases when the RS value exceeds 1. This happens when Average Gain exceeds the Average Loss. The RSI decreases when the RS value falls beyond 1, i.e. goes negative. This happens in strikingly opposite scenario, where Average Loss exceeds Average Gain. Theoretically, if Average Loss is 0, the RSI is 100, which is the maximum value for the RSI.
While using overbought or oversold values, Wilder suggested using 70 and 30 respectively. So, the scenario becomes bullish when the RSI crosses 30 and bearish when it is low than 70. The traders hence identify the entry / exit points with the help of strong signals.