EN
The struggle to understand the price trend is real, which is why chartists always search for techniques that will help them understand market moves in advance. Using tools like candlestick charts, Bollinger Bands, and many more, traders continuously try to identify when market sentiment is changing.
Momentum oscillators are one such set of tools that help traders understand the strength of a price trend. These help measure price change, determine the strength of the price trend, and identify the point of inflexion. Unlike a simple moving average, RSI is a momentum oscillator that can help identify potential trend changes, though it's based on historical price data.
Key Takeaways
-
Relative Strength Index (RSI) is a commonly used momentum indicator to analyse buy and sell signals in the price chart
-
RSI helps determine the speed and magnitude of price changes in the market
-
RSI divides price charts into several regions between zero and hundred, helping traders study the price line between the two extremes
-
An RSI value can show a false signal when a stock appears overbought but continues to rise, or appears oversold but continues to fall
What is the Relative Strength Index (RSI) Indicator?
The answer to what is relative strength index in simple terms is that it is a momentum indicator to measure the magnitude of price change. It is one measuring unit that helps traders understand when a stock is overbought or oversold. RSI calculates the strength of a stock trend and predicts reversals.
This analysis tool, developed by J. Welles Wilder, is calculated across a 14-day period and provides values ranging between 0 and 100. An RSI value above 70 indicates that an asset may be overbought, while a value less than 30 implies that it has been oversold. If the value falls between 30 and 70, it indicates a neutral zone where the trend may be strengthening or weakening without reaching extreme conditions.
Background of RSI
In the same book, J. Welles Wilder also introduced RSI or Relative Strength Index, an indicator on a range of 0 to 100, which indicates if a stock is overvalued. Usually, if a stock price moves above 70 RSI, it is considered overbought. Likewise, if a stock price falls below 30, it is deemed to be oversold.
Apart from indicating when a market is bullish or bearish, RSI is also used to gather ideas about general trends.
The Formula for Calculating RSI [H2]
RSI is calculated using the following formula:
RSI = 100 - ( 100 / 1 + RS )
RS = Average gain/Average loss
How Does the Relative Strength Index Work
RSI works by estimating if an asset is potentially undervalued or overpriced after analysing its recent losses or gains. The Relative Strength Index is calculated after comparing the recent price movements of an asset to understand if the market is heading towards a bullish or bearish situation.
In a bull market, where prices continue to rise, RSI tends to remain elevated for longer periods, typically fluctuating between 40 and 90, rarely entering oversold territory. The value fluctuates between 40 and 90. On the contrary, if the market is bearish, the value ranges between 10 and 60. Remember that these values can vary based on the RSI parameters and the strength of the market trend.
How to Calculate Average Gain or Loss
If we consider this RSI formula is calculated on a period of 14 days, as suggested in Wilder’s book then,
First Average gain = ∑of gains over 14 days’ period/ 14
First average loss = ∑of loss over 14 days’ period/ 14
2nd average, and subsequent average, is calculated as,
-
Average Gain = [(previous Average Gain) x 13 + current Gain] / 14
-
Average Loss = [(previous Average Loss) x 13 + current Loss] / 14
The practice of taking prior values and current values together is called a smoothening technique, which helps RSI become more accurate in technical analysis.
Wilder’s formula was an improvement on calculating RS, which turned it into an oscillator that swings between ‘0’ and ‘100’ to indicate when the market is more volatile or less. RSI shows zero value when the Average Gain value equals zero. For example, over a 14-day period, an RSI of zero indicates that prices have declined every day with no gains to measure.
Conversely, RSI is 100 when prices have risen every day over the 14 day period with no losses.
The default lookback period for RSI is 14. However, traders adjust the value to determine increased or decreased sensitivity.
Remember, a smoothening effect will cause the RSI value to differ slightly. RSI calculated on a period of 250 will have more smoothing effect than RSI calculated on 30 periods.
Let’s discuss RSI with an example,
Let’s say there was a gain of 1 percent for seven days on 14 days’ period. And, an average loss of -0.8% for the remaining seven days. RSI is calculated as,
The General Rule Of Thumb To Study RSI Indicator
RSI indicates an overbought condition in the market and helps traders identify opportunities to book profits. It also identifies oversold stocks for a potential reversal. RSI divides price charts into several regions between zero and hundred, and traders study the price line between the two extremes. The area between 30 and 70 is the most studied region, with values below 30 indicating oversold situations and above 70 indicating overbought situations.
It also helps identify general trends: uptrends typically show RSI above 50, while downtrends show RSI below 50.
While studying RSI, divergence is what you should be looking for. RSI divergence indicates the point of inflexion, where the price line may change direction.
Wilder categorised divergence as positive and negative divergence. He opined that directional movement doesn’t confirm a price, and so you need to identify deviation for a potential change in trend. Divergence is a condition where the price line and RSI move in the opposite direction.
Positive divergence occurs when RSI makes a higher low while the price line registers a lower low.
Conversely, when RSI registers a lower high against a higher high of the price line, a negative divergence happens. Chartists look for points of divergence in price charts to plan entry and exit points in the market.
How to Interpret an RSI Indicator
- During a bullish market, a stock's RSI may reach the overbought level of 70 repeatedly over an extended period. If it happens then, RSI value can be adjusted to 80, showing strong trends.
- RSI provides more information than a price line chart. It gives details such as, double tops or double bottoms which a line chart can’t explain. Further, it also sheds lights on the support or resistance level of stock.
- In a bullish market where RSI remains between 40 and 90, the RSI level between 40-50 typically acts as a support zone, with pullbacks rarely falling below this range. Similarly, in a bear market between 10 and 60 range, the region between 50 and 60 acts as resistance.
- Divergence occurs when a price line shows a new high or low that isn’t confirmed by the RSI indicator. It is a critical indicator which shows a price reversal trend.
- Top Swing and bottom swing failures are also forms of divergence. When RSI marks a lower high which is then followed by a downside move below a previous low, a Top Swing Failure is said to have taken place. Similarly, when RSI makes a higher low, which is then followed by an upward move above a previous high, a Bottom Swing Failure occurs.
Importance of RSI Indicator
Here are a few advantages of the Relative Strength Index to analyse the market scenario.
-
RSI helps traders understand the market momentum by analysing the price fluctuations.
-
The Relative Strength Index also helps in signalling potential trend reversals before they become evident on price charts.
-
RSI enables traders to understand whether a stock is oversold or overbought.
-
It is a versatile tool that can be applied to a diverse range of asset types and timeframes.
-
RSI can act as a leading indicator in signalling a change in the coming trend, even before the price chart confirms it.
-
RSI acts as a confirmational analysis tool, enabling traders to make reliable and accurate trading decisions.
Limitations of RSI
Like any other indicator, RSI results are most reliable when they conform to long-term trends. Actual reversal signs are rare and need to be filtered from false signals. An RSI value can show a false signal when a stock appears overbought but continues to rise instead of declining. Similarly, a false signal occurs when a stock appears oversold but continues to decline instead of rebounding.
Secondly, the RSI indicator can stay in the overbought or oversold range for a long time while the stock in question shows the opposite movement. So, it is more useful in a scenario where the price keeps alternating between bullish and bearish ranges.
Conclusion
RSI is a momentum oscillator indicator that provides traders with a visual representation of when price trends may be shifting. When used with awareness of its limitations, it is a powerful tool for identifying potential trend reversals.
While RSI helps identify overbought or oversold situations, it is always ideal to use this in conjunction with other analysis tools. This should not be your sole indicator when making trading decisions. Hence, you need to consider RSI divergence when analysing the market trend.
Make sure to understand the limitations and functions and how RSI indicator works to improve your trading strategy. Combining RSI with other tools enables you to get a comprehensive view of the market trend, helping you identify reversals accurately.