What Is Relative Strength Index (RSI) in Stock Market: Its Indicator And How to Calculate it?
Traders and investors in stock markets use different tools to select the right stock and maximise their gains. They use technical and fundamental analysis of stocks for such purposes. One such technical indicator popular among traders is the Relative Strength Index or RSI.
RSI tracks the price movements of the stocks and arrives at a conclusion about whether a stock is overbought or oversold. This allows traders to take appropriate positions in the markets. This article helps you understand the concept of relative strength index and how it is different from relative strength. Read on!
What is Relative Strength Index (RSI)?
J. Welles Wilder Jr. introduced the concept of Relative Strength Index (RSI) in 1978 in his book named New Concepts in Technical Trading Systems. RSI computes the price movements of stocks through a ratio of the upward movement in prices to the downward movement in prices over a specific time period.
These data points are plotted on a scale whose range is 0 to 100. As per technical interpretation, if the numbers on this scale cross the 70 mark, it signals that traders are overbuying that particular stock, and there may be a correction in their prices. On the other hand, an RSI value of 30 or lesser indicates that stocks in consideration are being oversold in the market.
What is RSI Range Shift?
The RSI range shift occurs when the RSI indicator moves away from one range to another due to changes occurring in the prices of stocks or any other asset class. There are five different relative strength index ranges which are as follows:
- Super Bullish: Whenever the RSI range is between 60-80, it comes under the super bullish category. In this, RSI does not fall below 60 and swings vigorously between 60 and 80.
- Bullish: This occurs when RSI swings between 40 and 80. It does not fall below 40 and tends to settle near the 40 mark. However, in the case of a strong bull run, it may settle near 80 as well.
- Bearish: This indicator shows bearish tendencies in the market or for that particular stock. The range of the bearish scale is between 20 and 80. When stock is on a downward trend, then it may meet resistance near the 60 mark.
- Super Bearish: A super bearish range shows levels between 20 and 40 on the RSI scale. The stock will not cross the 40 mark if there are severe downward or bearish tendencies.
- Sideways: The levels indicated in the case of a sideways range are between 40 and 60. It will not show any concrete trend about the particular stock or markets in general. A stock may find support near the 40 levels, but at or near 60, it will face resistance.
How does the RSI Indicator Work?
The RSI is a momentum indicator that measures the magnitude of recent price changes for various assets. The tool assesses the current and historical prices of a stock or market based on the closing prices of a recent trading period. It computes the momentum and signals investors whether a particular stock is overbought or oversold.
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How to Interpret the Relative Strength Index (RSI)?
This index helps traders assess whether they should buy or sell a particular stock based on the market trends. If the RSI indicator crosses level 70, then it signifies that the stock is overbought, and when it is lower than 30, then it shows that the stock is oversold.
The RSI may form various chart patterns like double tops or double bottoms, trend lines, etc. These patterns may not be visible on the underlying price chart. The RSI may fluctuate between 40-90 and 10-60 depending on the market conditions; upward or bull conditions for the former range and downward conditions for the latter range.
If the stock reaches a high or low, which is not reflected in the RSI, it indicates a price reversal. Now, in case the RSI shows a lower high level and then starts moving downside, then it will indicate Top Swing failure. On the other hand, if the RSI shows a higher low level and starts an upward movement, it indicates a Bottom Swing failure.
What is the Relative Strength Index Formula?
The basic RSI indicator formula is as follows:
RSI = 100 – [100/ (1+ (Average Upward Price Change/ Average Downward Price change))]
How to Calculate Relative Strength Index (RSI)?
The relative strength index calculation is fairly simple if you break the total formula into its most basic components. It includes relative strength, average loss and average gains of a particular stock over a period of time, specifically 14 days.
It involves 3 steps of calculations which are as follows:
- Step 1: First, compute the average gains and average loss of a stock over a period of 14 days. You must monitor the prices every day and record the change in prices over the previous day.
If there is an increase in prices, then you need to add that to the total gains component. If there is a fall in the price level over the previous day, add it to the total loss variable. At the end of the 14-day cycle, divide the total gains and total losses separately by 14 each to get the average. - Step 2: Next, calculate the relative strength (RS), which is the ratio of average gains and average losses.
RS = Average Gains/Average Losses - Step 3: In the final step, compute RSI using its formula:
RSI = 100 – (100/ 1 + RS)
After plugging in all the values in the formula mentioned above, you will get the RSI value of a particular stock.
The RSI value will oscillate between 0-100 as per any changes occurring in the value of the variables. If the value is more than 70, the stock is overbought, and any value lower than 30 indicates heavy selling of that particular stock.
What are the Limitations of the Relative Strength Index (RSI)?
Here are some limitations of the RSI that traders and investors should keep in mind:
- Time Horizon: This index caters to changes in price movements over a span of 14 days; hence, it may give reliable signals over a long-term horizon. However, it will take time to reflect the swift changes occurring in the market.
- Narrow Base: RSI only considers price changes and does not take into account other important parameters like volume and open interest. Therefore, it may provide ambiguous signals about whether one should go for buying or selling a stock.
- Unable to Perform during Strong Trends: This indicator will not be helpful for traders when there are strong trends in one direction. It is most efficient when the asset prices keep oscillating between high and low levels. In fact, it may provide false buying or selling signals during such scenarios.
- False Signals: Traders might find it difficult to distinguish between a correct price reversal signal and a false alarm of buying or selling. If a price reversal indication is a false alarm, it may lead to wrong trading decisions.
Difference between Relative Strength and RSI
Many traders tend to confuse relative strength as relative strength index; however, these two are distinct variables. Relative strength shows the performance or value of a stock in comparison to other stocks or indices.
On the other hand, a Relative Strength Index shows the present performance of a particular stock in comparison to its recent performances.
Final Word
The Relative Strength Index is an important technical indicator that gives traders an idea about the position that they should take in stock markets. However, in order to get the best results, traders must use both fundamental and technical indicators. Using the RSI may help to develop a perfect trade strategy.
FAQs
Ans: The divergence happens when the underlying price of a stock and its RSI value do not align with each other. In case a stock hits higher highs, RSI might show a lower high value. On the other hand, if a stock hits a lower low value, the RSI can indicate a higher low value for that stock.
Ans: Many investors and traders prefer buying a stock if the RSI shows a value less than 30. This means that there is heavy selling in that stock, and it may rebound in future. This indicates a buy signal. However, some traders do wait for other confirmatory signals before going ahead with their trade.
Ans: RSI is a widely used technical analysis tool used by various traders. It is most reliable in the long term as it can reflect significant changes in market prices. However, one must use other indicators as well to cover any error in RSI.
Ans: Generally, traders use RSI to assess stock prices against a 14-day timeframe. However, day traders generally prefer 8-11 days; again, this is not a uniform timeframe, and different traders may adjust the RSI range depending on market situations.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
