What is Relative Strength Index (RSI) ? | Espresso

Relative Strength Index (RSI) – Everything You Need to Know

You might have seen stock pricing charts displayed at trading terminals. These charts help traders in analysing the market and predicting future price movements of stocks. They consist of colourful lines plotted in smaller panels in between a graph-like structure. These lines are technical indicators that reflect various market parameters related to stocks.

Published on 05 April 2022

Some of the most common technical indicators used by traders include moving average, volume, open interest, Bollinger bands, and relative strength index. In this article, we will learn about the relative strength index or RSI, which is one of the most popular momentum indicators used for market analysis.

Let’s start by knowing what is a momentum indicator before understanding what is relative strength index.

What is a Momentum Indicator?

A momentum indicator reflects the velocity of a stock’s price trend. In other words, it indicates the speed at which the price of stock changes at a given point in time. For example, let’s suppose the price of a stock was ₹400 on Monday. Then, on Tuesday, it surged to ₹420 and to ₹440 on Wednesday. Now, the momentum indicators will show a high momentum as the price of this stock has moved by 10% in just two trading days.

Similarly, if a stock takes two months to move by 10%, the momentum indicators will show a low momentum. They help in analysing how quickly the price of a stock or security is changing.

There are several momentum indicators, with the Rate of Change (ROC) and the Relative Strength Index (RSI) being the two most common ones. First, let’s learn about the RSI indicator in detail.

What is the Relative Strength Index (RSI)?

The Relative Strength Index or RSI is one of the most commonly used momentum indicators for stock market analysis. It measures the speed at which the price of a particular stock or index changes on a scale from 0 to 100. Traditionally, a stock is said to be overbought if its RSI is above 70 and oversold if its RSI is below 30.

The RSI indicator was originally developed by J. Welles Wilder in 1978. It is displayed like an oscillator, i.e., a line graph that moves between the two extremes. It can be used to spot the current market trend, failure swings, reversals, divergences, and centerline crossovers.

RSI Calculation

You can calculate the RSI for a stock by using a fairly simple formula. The basic formula for the calculation of the RSI is:

RSI = 100 - 100 / (1 + (Average of Upward Price Change / Average of Downward Price Change))]

The average of the upward price change and the average of the downward price change used for the calculation of the RSI as per the above-mentioned formula is the average percentage gain or loss in a stock’s price during a look-back period.

How Does RSI Work?

The RSI indicator can be a powerful tool to measure the strength of a stock or index at a given point in time. You can also use it to spot the current market trend, failure swings, reversals, divergences, and centerline crossovers.

During an uptrend or bullish market, the average of upside price movements increases, and hence, the RSI value tends to be between 40 to 90. The 40 to 50 zone is usually considered as the support zone for a stock. So, if a stock is showing an RSI value between 40 to 50, it can show a surge in pricing in the short term.

However, if the RSI value of stock ranges above 70, it is considered overbought, which can be a signal of price reversal. So, traders usually take short positions in such instances.

Similarly, if there is a downtrend or bearish market, the average downward price change goes up, and hence, the RSI value tends to remain between 10 to 40. Therefore, the 30 to 40 zone is considered as the resistance zone for a stock, whereas an RSI value of below 30 indicates that a stock has been oversold, which again can be a sign of reversal.

Now, if the underlying stock makes a new high or new low against the RSI rules, it forms a divergence. If the RSI forms a lower high or a higher low and then follows it with a downside or upside move, a swing failure occurs.

Limitations of the RSI

The RSI indicator has some limitations as well. For example, it compares the upward and downward moving average and is displayed as an oscillator between the two extremes of the price chart. Therefore, the RSI signals are most reliable only when the price movements are as per the long-term trends. Sometimes, it can become difficult to distinguish between a reversal signal and a false alarm.

For example, a bullish crossover followed by a sudden decline in a stock’s price can result in a false positive, and a bearish crossover followed by sudden acceleration can result in a false negative.

To Conclude

The relative strength index is a powerful technical indicator that can help you determine entry and exit points for your trades. You can also watch it for divergence signals and changes in market trends. That being said, the RSI indicator has some limitations as well. So, it’s prudent to confirm your speculations with a few more technical indicators before initiating a trade.

 

Chandresh Khona
Team Espresso

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