Last Updated on May 24, 2022 by Anjali Chourasiya
Technical analysis has a lot to do with identifying early signs of price changes, pullbacks, and trend reversals. This is why technical analysis comprises numerous indicators that help traders gauge price movements in securities.
Typically, indicators are of two types, leading and lagging. The first one leads the price, i.e, it predicts the possible price movements ahead of its actual occurrence, while the second one follows the price, i.e, it indicates a price change that has already occurred.
One such commonly used leading indicator is RSI or Relative Strength Index. Besides predicting the price momentum, RSI also measures the speed of price change.
Let us understand RSI in detail.
Table of Contents
What is RSI?
Relative strength index is a momentum oscillator that is used to track the price changes in a security. RSI can range between 0 to 100 and is displayed on a line graph generally placed below the stock chart. The bands of RSI (generated and known as RSI lines) help determine the strength of the price momentum.
The RSI line runs between the two extremes and determines overbought and oversold conditions in the security. Ideally, RSI is measured over 14 days.
The traditional interpretation of RSI indicates that when any security’s RSI is below 30, it is oversold. There is a better possibility of a trend reversal or a correction at such extreme points.
Similarly, when the RSI rises above 70, the security is considered overbought, and a price reversal or correction may be expected. Some traders even use 25/75 or 20/80 as their oversold and overbought levels for RSI.
Swing traders are always looking for trading signals from RSI. They keep an eye on stocks where price momentum is fading out or picking up strength.
How is RSI calculated?
The formula for RSI is too complex for traders to manually implement it each time they plan to research a trade. To have a comprehensive knowledge of the concept, we have a simple formula that doesn’t ask for too many technical implications.
RSI = 100 – [100 / (1 + (Average of Upward Price Change / Average of Downward Price Change)]
That said, most new-age trading platforms have inbuilt services that display the RSI and RSI lines on your screen when you select the options.
Interpretation of RSI
RSI near the horizontal line having the value 30 is a bullish signal. In other words, it indicates that the accumulation of sellers in the stock has reached a saturation level, and a trend reversal is on the cards.
RSI near 70 and above is a bearish signal. It indicates the exhaustion of the upward momentum in the stock as the accumulation of buyers has reached a saturation point.
When the stock is in bullish momentum, the RSI generally stays above 30 and rarely falls below 30. It hits the 70 mark frequently. Likewise, for a stock experiencing bearish momentum, the RSI will rarely hit the 70 mark. It will trade close to 30 and below it.
Understanding RSI divergence and convergence
It is possible that RSI may not justify the price movement, and when this happens, the financial world refers to it as ‘divergence’. A divergence is experienced when the price of a security moves against the trend predicted by the indicator.
The resultant is a positive divergence when the higher lows of RSI are aligned with lower lows of the price, provided the RSI shows an oversold reading. Similarly, a negative divergence is seen when the RSI curve forms a lower high complemented by higher highs on the price curve.
Divergences occur in trending markets and find almost no relevance in sideways markets. The same also loses its relevance in the long term.
RSI convergence is generally formed when the price is falling. This usually happens at the tip end of a bear market. It also indicates a reversal in trend, indicating that the price may soon rise (bear market). It is usually formed before the reversal can happen and therefore is an early signal generator.
But it is not necessary that an RSI convergence should indicate a reversal. The price may continue to fall and hence calls for caution from a trader.
Note: RSI reveals dependable trading signals and is less prone to false signals when compared to other oscillators. But the same must always be used alongside other indicators for trade calls.
Strategies devised to trade RSI
While 70 and 30 are the two absolute confirmation levels, the movement of RSI towards these levels can also be considered as an entry or exit point.
When the RSI crosses the centerline (50) from below and marches towards 70, the same is a good enough indication to go long. Similarly, when RSI breaches the centerline from above and moves towards 30, the same is confirmed to enter short positions.
RSI can be combined with other technical indicators like MACD and moving average crossover to confirm trades.
Conclusion
RSI is an important indicator in the technical analysis of stocks. The 30/70 criteria of RSI is a standard amongst traders and is widely used in the financial world. RSI of 70 indicates an overbought zone for the stock and hints about a reversal of continuing bullish momentum in the stock. Meanwhile, an RSI of 30 is a cue for the end of a bearish trend in the price.
RSI being a leading indicator, can predict the price movements, corrections, pullbacks, and trend reversals ahead of several lagging indicators like MACD. RSI comes in handy while picking entry and exit points in traders and also in maintaining stop losses. Nonetheless, RSI must always be used in conjunction with other indicators when devising strategies for trade calls.
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