What is Relative Strength Index and how is RSI calculated, Interpreting RSI Values, RSI Trading strategies with example, Divergence in RSI, Combining RSI with other Indicators.
Description
Relative Strength Index RSI is one of the most used technical analysis tool. Originally developed by J. Welles Wilder Jr. in his 1978 book, RSI has become a very popular trading tool in attempting to isolate buy and sell entry/exit points in the equities, forex or commodities markets.
Here we will learn what is RSI and how to calculate it, use of RSI in day trading. In the end you will learn how to best these indicator in your trading strategy and when RSI setup fails and when it works.
What is Relative Strength Index (RSI)?
RSI is a also a momentum oscillator that measures the speed and change of price movements. The RSI is plotted between 0 to 100 and is primarily used to identify whether an asset is overbought or oversold.
- Overbought: This is the term assigned to an asset that is seen to be overpriced and trading more than its fair value; generally on the RSI scale above 70
- Oversold: A term given to an asset which is considered as undervalued and trading below its reasonable value, usually less than 30 on the RSI scale.
These are called levels where traders can know when to enter and exit the trade according to overbought and oversold levels in RSI.
How is RSI Calculated?
RSI is calculated using the following formula:
- RSI=100−100/1+RS
Where RS=Mean Gain over N periods / Mean Loss over N periods
Steps to Calculate RSI:
- Calculate the gains and losses for each of these days over a selected period (eg: 14 days).
- Calculate average gain and loss values.
- Relative Strength (RS)= (Average Gain)/(Average Loss)
- Use this formula and find the RSI.
Example:
Here are the number of daily gains and losses for a stock over 14 days:
- Gains: 2%, 3%, 1.5%, 2.5%
- Losses: -1%, -2%, -1.5%
This formula can help you to calculate RSI, It will display when the stock is near to overbought or oversold
Interpreting RSI Values
The RSI value can provide critical information about the market behavior.
RSI Above 70:
- Signifies the asset might be overbought.
- Buyers losing power, so there might be a reversal or pull back.
RSI Below 30:
- Possible indication that the asset is oversold.
- Indication of potential turning point in price as sellers become exhausted.
RSI Between 30 and 70:
- Characterized as a market that is neither overbought nor oversold.
- Low directional bias, mainly sideways market when RSI is around 50 level.
Key Points:
While RSI levels of 70 and 30 are standard, some traders adjust these thresholds to 80 and 20 for more sensitive signals in volatile markets.
Divergence in RSI
The moment the price of an asset behaves contrary to the RSI, divergences form. These can be strong signals for a reversal. When the asset price is moving in the opposite direction to RSI it is called divergence, and can be a powerful signal for reversal.
Bullish Divergence:
- A bullish divergence happens when the price is forming lower lows but RSI makes a higher highs.
- It signals weakening bearish momentum and a possible upward reversal.
Bearish Divergence:
- When price makes higher high and RSI makes lower high.
- Indicates that the bullish momentum could weaken and a possible reversal towards downside.
RSI in Different Market Conditions
Hence the character of an RSI is different for trending vs non-trending (range-bound) markets
In Trending Markets:
- The RSI can stay in overbought or oversold longer periods.
- Traders often combines RSI with other indicators such as moving averages and exponential moving average to avoid false signals
As the market is trending upwards, the RSI remains in overbought area for the whole day. For a potential reversal trade traders us EMA for confirmation. A strong red candle closing below EMA can indicate a trend reversal, place the stoploss above red candle and target will be recent swing low or RSI coming near oversold area.
In Range-Bound Markets:
- In range bound or sideways market RSI works best for identifying overbought and oversold areas.
- Price is more likely to range or reverse, so those reversal signals are higher probability.
In range bound markets RSI signals are more reliable as price oscillates within a range. Traders use multiple indicators such as EMA, Bollinger bands, pivot points with RSI for trend reversal signal near overbought and oversold RSI level.
RSI Trading Strategies
Oversold and Overbought strategy
- Purpose: Look for Reversals
- Approach: Long when RSI crosses under 30 and moves back above it, Short when RSI moves above 70 and moves back below it.
- Caution: Not all overbought (or oversold) necessarily lead to a price reversal. Place further confirmation signals.
RSI Divergence Strategy
- Purpose: Detect trend reversal based on price & RSI divergence.
- Approach: In a downtrend, seek bullish divergence and in an uptrend, Try combining it with candlestick patterns or support/resistance levels for even better clarity.
Advantages of RSI
- Ease of Use: It is easy for the most inexperienced traders to interpret RSI.
- Versatility: Whether you trade stocks, ETFs or options, own a large-cap or small-cap stock portfolio, you need a CONCRETE plan that will allow you to good money trading.
- Momentum Insights: Shows direction of price flow and reversals
Limitations of RSI
- False Signals: RSI gives early signals in strong trends.
- Overbought/oversold duration: As a result, in trending markets RSI can become overbought or oversold for an extended period of time and losses can be big if you would trade it blindly.
Combining RSI with Other Indicators
To avoid the false signals while using RSI, traders usually try to use it in conjunction with any of the following tools:
- Moving Averages: Using moving averages to Confirm the trends and filter out False signals.
- Bollinger Bands: Limit overbought and oversold readings with RSI using Bollinger Bands.
- MACD: MACD (Moving Average Convergence Divergence) — confirm divergences and momentum shifts
RSI on Indian Stock Market
In the Indian perspective, RSI is very popular indicator to analyze stocks with indices like Nifty 50 and Bank Nifty. Investors watch RSI levels that have been helpful in the case of shares such as Reliance, TCS or HDFC Bank. For instance:
- A stock e. g Reliance Industries may show an RSI of 75, which would indicate overbought conditions and likely reversal / pull back.
- On the other hand if TCS has a 25 RSI, it might mean that the stock is oversold and a possible bounce back.
Final Thoughts
The Relative Strength Index (RSI) is a great tool for anyone seeking reversals and momentum investment opportunities. RSI is useful for ascertaining such valuable insights of the market activity, but it should be combined with other trading systems and studied thoroughly by providing more depth to create a sound trading strategy.
By knowing the information, RSI can provide you can make informed decisions in any market. No matter if you gonna trade nifty 50 stocks, commodities or forex this one is mark my word: a must-have in your arsenal of Technical Analysis weapons.