The Relative Strength Index is probably one of the most popular momentum oscillators out there. To put it simply, the Relative Strength Index compares the average gains to the average losses of a stock and spits out a number between 1 and 100, if the number is over 50 then you are looking at an bullish stock where the average gains is higher then the average losses, and if the number is below 50, you have a market that is bearish on the stock., with the average losses being higher then the average gains. Probably the most common interpretation of the RSI is if the line goes above 70, then the stock is considered overbought, and if the line goes below 30 then the stock is considered oversold.

The RSI was originally created by J. Welles Wilder who first had it published in 1978 in the Commodities magazine, later that year he published it in his book “New Concepts in Technical Trading Systems”. Since then the RSI indicator has become a staple in most technicians play books. Like most indicators, by itself it is not fool proof (although it seems to hold out by itself a little better then the other comes ones), for this reason, I like to see Buy signals from multiple indicators before I initiate a trade.

Let’s take a look at how to calculate the RSI, although in the majority of cases you will never have to calculate this out yourself, it is always a good idea to have an understanding of what goes into an indicator, to make sure you don’t overlap signals from similar sources. RSI takes one input, we will use ‘x’ to display it, which is the number of periods it takes into consideration. RSI almost always uses a value of 14 for this input. All values used in the calculation are positive values. (Losses are calculated using non-negative values).

The Relative Strength Index = 100 – ( 100 / ( 1 + Relative Strength ) )

Relative Strength = Average Gains / Average Losses

Average Gains = ((previous average gains * (‘x’ - 1)) + current gain) / ‘x’

Average Losses = ((previous average losses * (‘x’ - 1)) + current loss) / ‘x’

To figure out the first average gain (or loss), you want to take the total amount of gains (or losses) over the past ‘x’ periods and then divide that total by ‘x’.

With this formula, you can now create the RSI oscillator on your own.

Now that we know how to calculate the Relative Strength Index, lets talk about how we actually interpret the information supplied by it. There are four main 'flags' that should be looked for when dealing with the RSI. The first, being when the line goes above 70 or below 30, like I stated before, when the line goes about 70, this means that the stock may be overbought, which means a correction / change in direction could be coming. The same goes for when the line goes below 30, this means that the stock may be Oversold, and that the price could start rallying again.
The next thing I like to look for is the actual position of the line in comparison to the 50 mark. If the line is above 50 then it generally shows that he stock is bullish and if it is below then it shows that it may be bearish. But if you experience a crossover from below to above or vise versa, this indicates a shift in the market opinion of the stock from bearish to bullish or the other way around.
The next thing to look for is divergences between the RSI line and the actual stock price direction. If you have a stock whose price is rising but the RSI line starts to fall, this could indicate that the market is starting to lose confidence and that the stock price will soon take the same direction as the RSI line.
The last one is the one that isn't normally mentioned, but I like to look for, its the direction of the RSI line, if the line is heading in an upward direction, then I like to think of it as being bullish, regardless if its above or below 50, and the same for the reverse.

Finally I'd like to show an example of an RSI line in use, refer to the following chart in the next few examples, the RSI indicator is at the TOP of the chart.

Example 1: Method 1: Overbought, between May 1st and May 15th we can see that the RSI line is above the 70 mark, which means that the stock is overbought, sure enough the RSI line drops below and the stock price declines.

Example 2: Method 2: Bearish, you can see that from June 28th (or around there) till July 21, the RSI line is below the 50 mark, and the price continues to decline, this is a great example of a bearish indicator.

Example 3: Method 4: Bullish, right after the bearish indicator from Example 2 we can see the last method coming into play, the RSI line is on the rise, and so is the price of the stock, this is a fairly good indication that the current market is bullish on the stock. this WILL come to an end, so just keep an eye on it and watch for the trend to end.

I hope that this has given you a good brief introduction to the Relative Strength Index, It is one of the most used indicators for a good reason. Please share any comments you have about this indicator in the comment below. If you have any tips or extra hints on how to use the RSI, please share!