What is Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a popular technical indicator used to determine whether an option is overbought (price too high) or oversold (price too low). The RSI fluctuates between 0 and 100, with a value below 30 indicating that the option contract is oversold, while a value above 70 indicates an overbought level.

Relative strength index calculation

The Relative Strength Index (RSI) is calculated as:

RSI = 100 - 100 / (1 + RS)

Where RS = (Average gain / n) / (Average loss / n)

n= time frame

Relative Strength Index - How to use

Traders use the RSI to identify a trend in the price movements of an option and to obtain buy/sell signals.

If the RSI is above 70, the option is in an overbought area and could see a price reversal.

An RSI below 30 indicates that the option is undersold and could see a price increase in the future.

Relative Strength Index advantages and disadvantages

Relative Strength Index advantages

• Easy to use: The RSI is a simple indicator that is easy to understand and use, so it can be used by beginners and experienced traders alike.
• Provides clear buy and sell signals: The RSI indicator is used in almost all major trading tools and plotted alongside a price chart.
• Works well with other indicators: The RSI can be used in conjunction with other technical indicators to confirm or contradict trading signals, which can help traders make more accurate predictions about price movements.

Relative Strength Index disadvantages

• Can lag behind price movements: The RSI is a lagging indicator that may not provide timely signals in fast-moving markets, which can lead to missed opportunities or losses. The RSI is good for confirming other indicators, such as a Bollinger Band, which can provide earlier entry signals.
• Few trading opportunities: Compared to other indicators, such as the moving average, there are few trading opportunities when using the RSI indicator. The lack of opportunities means that traders need to be patient and potentially trade many different markets at the same time.
• Losses are difficult to recover: The RSI can remain overbought or oversold for long periods, which can lead to significant losses.
• Can generate false signals: The RSI can generate false signals, especially in markets with low liquidity or when a sudden news event causes a sharp price movement. Therefore, if you are trading against the trend, you need to understand why the market is moving and what recent news is affecting prices.