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RSI: Relative Strength Index demystified

What is RSI?

The relative strength index (RSI) is a momentum indicator developed by noted technical analyst Welles Wilder, that compares the magnitude of recent gains and losses over a specified time period to measure speed and change of price movements of a security. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset.

RSI attempts to capture the following:
1. Recent gains and losses over a period of time,
2. Measure of speed and change of price movements, and
3. Overbought or oversold conditions in trading of a stock or Index.

Calculating RSI

1. Find out average gain during specified time frame.
2. Find out average loss during specified time frame.

Then calculate the RS value for each closing day.
RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame.

The relative strength index is calculated using the following formula:
RSI = 100 - 100 / (1 + RS)

The RSI provides a relative evaluation of the strength of a security's recent price performance, thus making it a momentum indicator. RSI values range from 0 to 100. The default time frame for comparing up periods to down periods is 14, as in 14 trading days.

Interpreting value of RSI

Traditional interpretation and usage of the RSI is that :-
RSI values >= 70 indicate that a security has becoming overbought or overvalued, and therefore may be primed for a trend reversal or corrective pullback in price.
On the other side of RSI values, an RSI reading of <= 30 is commonly interpreted as indicating an oversold or undervalued condition that may signal a trend change or corrective price reversal to the upside.

RSI is just an indicator and simplifies the behaviour of the stock price in the past. It is not a sure fire way of predicting the future trends of the asset price.

Seasoned traders usually use RSI in combination with other indicators like MACD and ADX to arrive at a conclusion about initiating or closing a trading position.
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