Understanding Relative Strength Index

Traders use technical indicators to help them make better trading decisions. A technical indicator on the chart can help a trader time their entry, time their exits, and set targets. Technical indicators are of 4 types: trend indicators, momentum indicators, volume indicators, and volatility indicators.  Each indicator has its uses and merits. 

What is the Relative Strength Index?

The RSI or Relative Strength Index is one of the traders’ most popular momentum indicators. RSI, first created by J.Welles Wilder Jr, measures the magnitude of recent price changes to indicate overbought or oversold market conditions. The RSI oscillates between zero and 100 on a graph. Generally, when the RSI is above 70, the stock is considered to be overbought. Whereas when the RSI is below 30, the stock is considered to be oversold. After the Simple Moving Average and Volume indicator, RSI is one of the first indicators beginners apply to their trading strategy. 

The Formula of the Relative Strength Index

Understanding the Relative Strength Index formula will enable us to understand it in a better way.

RSI = 100 –  [100 / 1+(Average of Upward Price ChangeAverage of Downward Price Change)]

The Average of Upward Price Change and the Average of Downward Price Change is simply the average percentage gain or loss during a period in the past. The standard time frame is 14 trading days. 

Calculation of Relative Strength Index (RSI)

The RSI indicator automatically plots RSI lines over a specific time period on a graph, so rarely one has to ever manually calculate the RSI. Nevertheless, knowing the Relative Strength Index formula, and understanding how to calculate the RSI can be beneficial for one. The RSI, at no point in time, can have a negative value. It is always a number between zero to hundred. The RSI will show an upward trajectory when the number and size of positive closes increase. On the other hand the RSI will fall, if the number and size of losses are higher.  

What Does the RSI Tell You?

The RSI indicates whether a stock or asset is overbought or oversold. However, many investors believe a stock or asset that shows an overbought reading on the RSI is going to fall soon. Likewise, they believe a stock or asset that reads oversold on the RSI scale is going to rise soon. However, this is not the case, so an overbought or oversold reading alone should not influence a position. While using the RSI indicator, one needs to check the existing long term trend of the stock price. 

If for a long period, the price of the stock is in an upward trend, the RSI reading may often read as overbought. That is, it is likely to hover around the 70 mark, and is less likely to read 30 or anything below. One may also see the RSI reading above 70 for an extended period if the upward trend is very strong or the market sentiments are very possessive. In such a scenario, if the investor or trader chooses to stay away from the stock or asset because its RSI reading reads overbought, it is possible that one could miss out on a good chance on making profits.

Similarly, in a downward trend, the RSI often fluctuates between zero and 30, and is unlikely to read above 50.  At times, it is likely to even hover next to zero, if there is constant selling pressure. Here, the RSI reading will remain in the oversold zone for an extended time until the negative sentiments fade away. In this case, if a trader takes a position in that stock, hoping it will go up, the trader will lose a lot of money. 

Interpretation of RSI and RSI Ranges

Generally, when the RSI shoots above 30, it is a bullish sign. If it plummets below 70, investors and traders need to brace for a bear market scenario. One can change the reference levels for overbought and oversold depending on the market conditions. For instance, in a strong uptrend, the RSI readings could frequently touch 90. It could barely fall under 60, and every time it came near the 60 level mark, it would go back to 80. Here, one could shift the labels and label the 90-level mark as overbought and 50 or 60 as oversold. 

The RSI can also warn traders about trend reversals during a market trend. That is, it can alert traders if an upward trend may reverse into a downward trend or vice-versa. The RSI is around the 70 mark or even higher. Whereas in a downtrend, it tends to stay below 30. However, in an uptrend, if the RSI shows a dip below 30, it indicates the trend has weakened, and one could see a potential downtrend from there. Similarly, during a downtrend, if the RSI shoots above 30, it could potentially be the beginning of an uptrend. 

RSI Divergence

In a downward trend, the Relative Strength Index (RSI) may move upwards while the stock price continues its downward decline. The above scenario may occur when the RSI forms a lower high despite the declining stock price. This indicates bullish momentum and a forthcoming bullish trend. This is a bullish divergence. Likewise, a bearish divergence occurs if the RSI, during an upwards trend, moves towards the oversold level while forming a higher low. This higher low will correspond to the increasing stock or asset price. 

Limitation of the RSI

After comparing the bullish and bearish price changes, RSI provides an oscillator below the chart. Like most technical indicators, RSI is best suited for long-term trading. Actual reversal signals can be rare due to false alarms that are created from time to time. 

A false positive could occur, and a bullish crossover is shown, but the share price decreases abruptly. False negatives could occur as well. A false negative is when the share price shoots up just when a bullish crossover is displayed. 

Being a momentum indicator, it can provide over-buying or over-selling signals for a long time when there is significant movement in share price in either direction. 

The best time to use the RSI indicator would be in an oscillating market, where the share price is constantly changing trends from bearish to bullish and bullish to bearish. 

Difference Between the RSI and Moving Average Convergence Divergence (MACD)

As the relative strength indicator, the moving average convergence divergence or MACD indicator is a momentum indicator. It has a signal line created from historical price movements provided by the exponential moving average ( EMA). RSI has a default time period of 14 days with values bound between 0 to 100

The MACD is created by subtracting the 26-period EMA from the 12-period exponential moving average. 

Along with the MACD, a nine-day EMA behaves as a signal line based on which buy and sell signals are generated. Trades use MACD by buying company shares when the MACD crosses over the signal line. Trades sell or short shares of the company when the MACD crosses below the signal line. RSI assists in knowing if the securities are being oversold or overbought

MACD gauges the change in the relation between EMA while the RSI provides information by comparing the change in shares price lows and highs. The two indicators combined paint a beautiful picture providing a clear technical view of the market. Even Though they both measure the momentum of an asset, the parameters they use are different. This could lead to both indicators providing contradictory signs and confusing investors in the process.

An example could be a situation where the RSI is at 75 for an extended period, indicating that it’s being overbought. The MACD could indicate an upcoming uptrend making the price increase even more. In such a situation, investors can get caught up if they should expect a reversal or follow the MACD for a possible bullish movement.

Conclusion

The RSI is a handy indicator, but one mustn’t base their trades on the RSI indicator alone. An indication the RSI suggests may not always play out. One should also take other important factors into account. The trend of the individual stock, the volume traded, the zone of support and resistance, and the market trend are other significant factors that one should consider. One could also incorporate other indicators along with the RSI to increase their chances of making better entries and making better gains.