The relative strength index was created by J. Welles Wilder Jr. in the late 1970s; his “New Concepts in Trading Systems” (1978) is now an investment-lit classic. On a chart, RSI assigns stocks a value between 0 and 100. Once these numbers are charted, analysts compare them against other factors, such as the undersold or underbought values. To reach the best evaluation, experts generally chart the RSI on a daily time frame rather than hourly. However, sometimes shorter hourly periods are charted to indicate whether it is a good idea to make a short-term asset purchase.
There has always been a little confusion over the difference between relative strength, which measures two separate and different entities by means of a ratio line, and the RSI, which indicates to the trader whether or not an issue’s price action is created by those over-buying or over-selling it. The well-known formula for the relative strength index is as follows:
\begin{aligned} &\textbf{RSI} = 100 – \left(\frac{100}{1 + RS}\right)\\ &\textbf{RS} = \frac{\text{Average of x days’ up closes}}{\text{Average of x days’ down closes}}\\ &\textbf{where:}\\ &RSI= \text{relative strength index} \end{aligned}RSI=100−(1+RS100)RS=Average of x days’ down closesAverage of x days’ up closeswhere:RSI=relative strength index
At the bottom of the RSI chart, settings of 70 and 30 are considered standards that serve as clear warnings of, respectively, overbought and oversold assets. A trader with today’s simple-to-use software may choose to reset the indicators’ parameters to 80 and 20. This helps the trader to be sure when making the decision to buy or sell an issue and not pull the trigger too fast.
Ultimately, RSI is a tool to determine low-probability and high-reward setups. It works best when compared to short-term moving-average crossovers. Using a 10-day moving average with a 25-day moving average, you may find that the crossovers indicating a shift in direction will occur very closely to the times when the RSI is either in the 20/30 or 70/80 range, the times when it is showing either distinct overbought or oversold readings. Simply put, the RSI forecasts sooner than almost anything else an upcoming reversal of a trend, either up or down.