RSI Indicator

The RSI is among the widely used indicators. There are ample information around explaining its use, so no point repeating here. But I do find a lack of simple explanation providing insights behind the formula. Perhaps I can add a little in this direction.



















To recap the RSI formula

RSI = 1 - (1/1+Rs); which keeps RSI within the range 0 to 1
or RSI(%)= 100 x RSI; range between 0 to 100%

where Rs = Avg(Gains)/Avg(Losses) over a period
The default period is normally set at 14

So this indicator basically takes the ratio of average gains/average losses

Hence when price movement is side way with Avg(Gains)=Avg(Losses), Rs = 1
RSI = 1/2 or 50%; the 50% line is visually useful too.

So it can be seen that if the
(average upward price movement) > (average downward price movement)
RSI > 50%

The 70% line is reached when Rs = 0.7/0.3 = 2.33 (by solving the formula)
i.e. (average upward price movement) = 2.33 times the (average downward price movement);
often taken as threshold entering the zone of price saturation being overbought.
I would simply interpret as Rs > 2 times.

Likewise, if the
(average upward price movement) < (average downward price movement)
RSI < 50%

The 30% line is reached when Rs = 0.3/0.7 = 0.433 (which I simply interpret as RS < 1/2)
i.e. (average upward price movement) = 0.433 times the (average downward price movement);
often taken as threshold entering the zone of price saturation being over sold.

One of RSI's usefulness is:

Its divergence from the price trend signals a potential trend reversal. This is revealed by lower values of Rs even as the prices move higher. This is also commonly visible on price charts as the "candle body" gets smaller (with a higher time frame) before a trend reverses. The RSI indicator shows this with more mathematical precision.