Here we'll look at introducing The Relative Strength Index, how it's calculated and how it's parameters can be changed depending on your trading style. Then we'll go on to talk about how it's traded in the next session. The Relative Strength Index (RSI) created by Welles Wilder in 1978 measures momentum in a financial instrument indicating overbought positions on the upside and oversold positions on the downside. The RSI measures this by comparing the size of its recent gains to the size of its recent losses as is shown in the formula below. This results in an index number between zero and 100 with centre line at 50. This indicator is then usually placed in a box just below the price chart and is calculated automatically in any good charting software or online package. Pictured below:

A number above or below the 70 or 30 respectively is considered overbought or oversold, indicating a possible momentum change.  RSI in best used in Range Bound Markets, but we'll also see how it can be used in trending markets. 

Now back to the equation. To simplify the calculation, RSI has been broken down into its basic components: RS, Average Gain and Average Loss. This RSI calculation is based on 14 periods, which is the default suggested by Wilder in his book. Losses are expressed as positive values, not negative values. Following is a spead sheet that shows the RSI calculation in action:

The very first calculations for average gain and average loss are simple 14 period averages. I've highlighted these in green in the above sheet

First Average Gain = Sum of Gains over the past 14 periods / 14.
First Average Loss = Sum of Losses over the past 14 periods / 14

The second, and subsequent, calculations are based on the prior averages and the current gain loss. I've highlighted these in blue
Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.

Taking the prior value plus the current value is a smoothing technique similar to that used in exponential moving average calculation. This also means that RSI values become more accurate as the calculation period extends. So how will this look on a chart? I've recorded it below:

In charting software you may be confronted with a couple of RSI options, eg Wilder RSI. Select the RSI option and generally the default value is set at 14, as suggested by Wilder. Some traders will adjust the period as part of their trading strategy – e.g if they’re looking for increased or decreased volatility in their system. Lowering the period will increase sensitivity and increasing it will decrease sensitivity - 10 day RSI will reach overweight positions more easily than 20-day RSI. We can see this in action below, where it's clear to see that the RSI 10 indicates overbought and oversold situations far more frequently than the RSI 20. This is telling us that within this reduced time frame there's more volatility an we may be subject to more trading opportunities.

To add more complexity some stocks will reach 30 and 70 more easily than others. E.g. a tech stock may be more volatile than a Utility and a market with many participants will generally be less volatile than a market with few participants. To reduce the amount of false overbought and oversold signals, some traders will increase the oversold and overbought parameters to 20 and 80. 

In fact some day traders will use 20, 80 and use a 2 period RSI to form signals and Swing Traders (Capturing gains in securities within a 1 to 5 day window) may look at an RSI 5 to form their signals. It all depends on your trading style and strategy and in time you'll find your own style. We’ll stick to 14 for now until we become accustomed to the RSI.

Next we'll look at how to trade The Relative Strength Index in RSI (ii)

Here we'll look at introducing The Relative Strength Index, how it's calculated and how it's parameters can be changed depending on your trading style. Then we'll go on to talk about how it's traded in the next session. The Relative Strength Index (RSI) created by Welles Wilder in 1978 measures momentum in a financial instrument indicating overbought positions on the upside and oversold positions on the downside. The RSI measures this by comparing the size of its recent gains to the size of its recent losses as is shown in the formula below. This results in an index number between zero and 100 with centre line at 50. This indicator is then usually placed in a box just below the price chart and is calculated automatically in any good charting software or online package. Pictured below:

A number above or below the 70 or 30 respectively is considered overbought or oversold, indicating a possible momentum change.  RSI in best used in Range Bound Markets, but we'll also see how it can be used in trending markets. 

Now back to the equation. To simplify the calculation, RSI has been broken down into its basic components: RS, Average Gain and Average Loss. This RSI calculation is based on 14 periods, which is the default suggested by Wilder in his book. Losses are expressed as positive values, not negative values. Following is a spead sheet that shows the RSI calculation in action:

The very first calculations for average gain and average loss are simple 14 period averages. I've highlighted these in green in the above sheet

First Average Gain = Sum of Gains over the past 14 periods / 14.
First Average Loss = Sum of Losses over the past 14 periods / 14

The second, and subsequent, calculations are based on the prior averages and the current gain loss. I've highlighted these in blue
Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.

Taking the prior value plus the current value is a smoothing technique similar to that used in exponential moving average calculation. This also means that RSI values become more accurate as the calculation period extends. So how will this look on a chart? I've recorded it below:

In charting software you may be confronted with a couple of RSI options, eg Wilder RSI. Select the RSI option and generally the default value is set at 14, as suggested by Wilder. Some traders will adjust the period as part of their trading strategy – e.g if they’re looking for increased or decreased volatility in their system. Lowering the period will increase sensitivity and increasing it will decrease sensitivity - 10 day RSI will reach overweight positions more easily than 20-day RSI. We can see this in action below, where it's clear to see that the RSI 10 indicates overbought and oversold situations far more frequently than the RSI 20. This is telling us that within this reduced time frame there's more volatility an we may be subject to more trading opportunities.

To add more complexity some stocks will reach 30 and 70 more easily than others. E.g. a tech stock may be more volatile than a Utility and a market with many participants will generally be less volatile than a market with few participants. To reduce the amount of false overbought and oversold signals, some traders will increase the oversold and overbought parameters to 20 and 80. 

In fact some day traders will use 20, 80 and use a 2 period RSI to form signals and Swing Traders (Capturing gains in securities within a 1 to 5 day window) may look at an RSI 5 to form their signals. It all depends on your trading style and strategy and in time you'll find your own style. We’ll stick to 14 for now until we become accustomed to the RSI.

Next we'll look at how to trade The Relative Strength Index in RSI (ii)