How Relative Strength Index Works?
1. Calculation of Average Gain and Average Loss: The RSI calculation begins by determining the average gain and average loss over the chosen time period.
2. Relative Strength: The relative strength (RS) is calculated by dividing the average gain by the average loss. This ratio indicates the magnitude of recent gains relative to losses. A higher RS suggests stronger upward momentum, while a lower RS suggests stronger downward momentum.
3. RSI Calculation: The RSI is then calculated using the formula,
[Tex]RSI=100-(\frac{100}{(1+RS)})[/Tex]
This formula converts the RS into an oscillator that ranges between 0 and 100.
4. Interpretation of RSI Values: RSI values above 70 are generally considered overbought, suggesting that the asset may be due for a price correction or reversal. Conversely, RSI values below 30 are considered oversold, potentially indicating a buying opportunity. Traders often use these overbought and oversold levels as signals for potential trading opportunities.
5. Monitoring RSI Trends: Traders monitor the RSI trends over time to assess the strength and momentum of the underlying price movements. Rapid changes in RSI values can indicate shifts in momentum, while divergence between RSI and price movements can signal potential trend reversals.