Hello friends, and welcome to this podcast by Angel One. Today, we are going to look at the huge difference between two very similar sounding indicators used in technical analysis. And these are Relative Strength Comparison or Relative Strength, and Relative Strength Index indicator, abbreviated RSI.
Are you excited? If not, you definitely will be by the end of this podcast!
Let’s look at the Relative Strength Indicator first. This is interchangeable called RS and RSC, but we will use RS over the next few minutes so as to not confuse you! Relative strength indicator simply tells you how a security is performing, in comparison to another base security. So in a way, RS can be looked at as a benchmarking tool, which can be used to pick stocks.
On the other hand, RSI, or relative strength index is an indicator that helps you determine if a security is overbought, or undersold. RSI is a momentum indicator. But before seeing why and how, let’s quickly revisit how RS works.
RS is calculated by dividing security A’s price with security B’s price along the same time period. When these values are plotted against time, we get a very simple visual way of assessing if security A is performing better than security B.
To do this, all you need to do, is to see if the line is going up or down. If it goes up, then A is performing better than B, while downward movement indicates the opposite.
You can measure A’s performance with it’s sector specific index, or even it’s market index. However, this doesn’t make it a relative strength index - this is a very common confusion amongst those who are new to trading. Then let’s look at what RSI actually is.
RSI is a momentum oscillator - meaning that the value of RSI oscillated between 0 and 100. We will see very shortly, why RSI is a momentum indicator.
So essentially, when RSI is plotted on a graph, it is basically a line oscillating between a value of 0 and 100 along the Y axis.
Technical analysts use RSI to understand if a security’s price gains and losses are a result of it’s overbought or oversold condition in the market.
Friends, how do we make sense of RSI values on a graph?
Great question. To do that, we draw two horizontal lines at 30 and 70. When RSI increases beyond 70, the underlying security is considered to be overbought. On the other hand, values below 30 indicate that the security has been oversold.
While this is useful information, it becomes even more intuitive when RSI values are plotted beneath a price chart. When we see a security’s price peak, at that point, if RSI is more than 70, then the upward momentum might be fading, because the security has been overbought. This indicates that a trend reversal is on the way, On the other hand, if the prices are moving along a downtrend and RSI is below 30, then the prices are likely to bounce back.
This gives us a very simple way of making sense of a security’s peaks and troughs.
The calculation of RSI is somewhat complicated. However, as an investor, knowing the meaning of RSI values can be very useful in avoiding misinterpretation of peaks as an upward momentum.
Friends, it is now time to look at some of the subtleties involved in interpreting with the RSI indicator.
Firstly, if you are curious as to how those magic numbers 30 and 70 came to the picture, then don’t worry - the fact is that they are not magic numbers. This is because RSI often swings between different bounds depending on the market situation. In case you are tempted to classify a security’s downtrend as its entry into the oversold zone, then you should pause for a moment - technical analysis works the best when you use indicators that are suitable for the market conditions and scenarios in which you are operating.
In fact despite having a clear signal from one indicator, it is always considered wise to use another signal to confirm whether the signal is actually a false alarm, or something to actually pay attention to. So while RS can help you understand if one security is performing better than the other, RSI tells you when a security’s price is climbing or falling due to it being oversold or undersold.
Another thing to look for when using RSI is to identify and adjust the overbought and oversold levels when the conventional levels fail to capture trend reversals.
When using RSI to spot trend reversal, it is crucial to understand that the signals that it produces are reliable, only when they conform with the long term trends. Moreover, if you are having difficulty resolving false alarms from real signals, it is best to look for confirmation, rather that hoping for expected movement,
Friends, both these indicators are very useful in understanding markets - while RS is a technical indicator that is useful for comparing and selecting the right stocks, RSI can help you understand the subtleties of price movements if done right.
That is all we had for today’s podcast, dear friends.
If you are still confused, then worry not - you can always check out our other podcasts, or simply visit www.angelone.in to learn more about the markets.
Until the next one, goodbye, and happy investing!