Measuring the dynamics of a market can be an interesting thing for investors since it allows them to compare the gains and losses of an asset over a given period. There are several technical indicators that provide such information, but one that is particularly popular with traders is the RSI, also known as the Relative Strength Index. We will therefore try to explain here in detail how to use and interpret this indicator which informs us about the strength of a market through a complete presentation of the method.
The RSI is a technical analysis procedure developed by an analyst, J. Welles Wilder, in 1978 and which was even the subject of a book entitled "New Concept in Technical Trading System".
Today, the Relative Strength Index is one of the most widely used indicators around the world by technical analysts and both retail and institutional investors.
The function of this indicator is to report on the dynamics of a given market, i.e. its strength, by comparing the gains and losses made over a given period.
To achieve this, the RSI takes into account only the closing prices of the underlying asset. It is a bounded indicator whose value oscillates between 0 and 100.
Beware, unlike other indicators of this type and despite the name "Relative Strength", the RSI does not compare the stock to an index and therefore to a market, but only measures the internal strength of the asset. Losses are expressed here as an absolute value and not as a relative value.
While it is possible to use different time periods to analyze the RSI, it is advisable to limit yourself to periods 5, 9 and 14 only. Of course, it is best to test several periods to see which one is the most effective.
As we have seen above, the ROI uses a comparison of losses and gains over a period of time. Therefore, we can say that its formula is as follows:
Note that G is the average of the gains and P is the average of the losses.
The interpretation of the RSI is intended to give an indication of how fast the market is going up or down. To perform a proper RSI analysis, the following fields are used:
We would like to draw your attention to the fact that the RSI, as interesting as it is, should not be used alone to determine a buying or selling opportunity. It is indeed essential to couple the information obtained with other types of indicators such as supports and resistances. By coupling the indications obtained through several indicators, we can obtain much more convincing buy or sell signals.
Another interesting indicator to use alongside the Relative Strength Index is the divergence indicator. This occurs when the price of an asset moves in the opposite direction of the indicator. These divergences are extremely reliable when used in oversold or overbought areas of the RSI.