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!
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.
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:
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.
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.
The basic RSI indicator formula is as follows:
RSI = 100 – [100/ (1+ (Average Upward Price Change/ Average Downward Price change))]
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:
Here are some limitations of the RSI that traders and investors should keep in mind:
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.
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.
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.
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