The Relative Strength Index (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent losses. It is calculated as follows: RSI = 100 - (100 / (1+ RS))
where RS = AU / AD
and AU = Average of the 'up closes' = number of days where the price closes higher than the open / number of days
and AD = Average of the 'down closes' = number of days where the price closes lower than the open / number of days
The number of days used in the formula is a matter of preference. The default value for stocks is 14.
The Relative Strength Indicator is scaled between 0 and 100. Traders can use the RSI to determine overbought and oversold conditions. A stock could be oversold when the RSI reaches 30, or overbought when the RSI reaches 70. To avoid false signals, some traders use more extreme values (eg. 20 as the oversold threshold and 80 as the overbought threshold).
Traders also use the RSI to identify divergence. Divergence occurs when the price makes a new high (or low) but the RSI does not reach new highs (or lows). It could be a bearish signal if the price reaches a new high while the RSI does not. For example, the price could rise from £60 to £65 while the RSI falls from 65 to 60. It could be a bullish signal if the price reaches a new low while the RSI does not. For instance, the price could fall from £45 to £40 while the RSI rises from 40 to 45. Accordingly, [Stan Weinstein] suggested that 'when you see inferior action in the RS line compared to the price performance, don’t ever buy that stock. Conversely, when you see a very positive relative-strength trend, do not consider shorting it.'
Parameters
Overbought - The threshold whereby a stock becomes overbought.
Oversold - The threshold whereby a stock becomes oversold.