Relative Strength Index (RSI) was introduced by J. Welles Wilder back in 1978, the RSI is a very popular and useful momentum oscillator. RSI ranges from 0 to 100 after comparing the magnitude of a stock's recent gains to the magnitude of its recent losses. In Wilder's book New Concepts in Technical Trading System, he recommended to use 14 periods as the parameter.
The following are the steps to calculate RSI
1. Calculate the advances and Declines of the closing price (differences between Current day closing price and previous day closing price).
If Current Day Closing Price is greater than Previous Day Closing Price then
Advance = Current Day closing price – Previous Day closing price
If Current Day Closing Price is Less than Previous Day Closing Price then
Decline = Previous Day closing price – Current Day closing price
2. Calculate the Average gains and losses (14 periods)
Average gain = Total Gain for the past 14 days / 14
Average Loss = Total Loss for the past 14 days / 14
3. Relative Strength (RS)
Relative Strength = Average Gain / Average Loss
RSI = 100 – (100 / (1 + RS))
Overbought / Oversold
Wilder consider a stock is overbought when the RSI reaches 70 and above, meaning that when it reaches 70 the speculator should consider selling. On the other hand, when then RSI reaches 30 and below it's consider as oversold and speculator should consider buying. This principle describes that when there is a large proportion of movement toward on direction, it suggests an extreme and price will reverts soon.
Level 80 and 20 can also be used but it's all depends on the sentiment of the market, some traders suggest to use level 80 as overbought signal during bull market and level 20 as oversold signal during bear market.
Level 30 crossover / level 70 crossover
When the stock crosses level 30 from above it shown that the stock is oversold. Most traders will monitor the stock closely and wait until it crosses level 30 from the bottom as a confirmation as a bullish signal.
When the stock crosses level 70 from the bottom it shows that the stock is overbought. Most traders will monitor it closely and wait until it crosses lever 70 from the top as a confirmation as a bearish signal
In RSI-Trader blog, we scan for more than 6000+ stock symbols in the NYSE and NASDQA for RSI overbought and oversold condition, level 30 and 70 crossovers. You can visit us at http://rsi-trader.blogspot.com .
For other tips, advice and scripts on how to perform you own market analysis, please visit DIY Traders page at http://www.diytraders.com .