Decoding RSI: What is Relative Strength Index and how is it used?

Summary

  • The RSI is a momentum indicator which oscillates between upper and lower bounds (0 and 100 respectively) to indicate overbought/oversold levels.
  • It also helps to spot divergences.
  • RSI works well as an indicator in a rangebound market. However, during a strongly trending market, it should be avoided.

When it comes to gauging the momentum of a security, there are many indicators available such as the Commodity Chanel Index (CCI), Stocastic oscillator, Rate of Change (ROC), etc. However, one indicator –the Relative Strength Index (RSI) – introduced in June 1978 by J. Wells Wilder, is probably the most popular amongst all of them.

Image Source:  © Dragon345 | Megapixl.com

Just like other oscillators, RSI oscillates between upper and lower bounds (0 and 100 respectively) to indicate overbought/oversold levels. The indicator is based on the assumption that after a significant advance in a relatively short span of time, the security tends to become overbought and hence is poised for a correction. Similarly, when a security has fallen sharply in a short span, it tends to become oversold, indicating the likelihood of a bounceback.

Read More: Volume; Why It is a Prominent data in Technical Analysis?

How is RSI calculated?

The indicator simply measures the strength of a security against its history of price change by comparing “up days” (when price has increased compared to the previous day) to “down days” (when price has decreased compared to the previous day). The formulae to calculate RSI are given below.

UPS= (Sum of gains over N periods)/N

DOWNS= (Sum of losses over N periods)/N

RS=UPS/DOWNS

RSI=100-[100/(1+RS)]

How to make decisions with RSI

  1. Overbought/Oversold Zones

As the RSI measures the intensity with which a security has risen or fallen, it is up to the user to decide the RSI levels where he would consider the security to be overbought/oversold. Traditionally these levels are below 30 for oversold and above 70 for overbought. However, they can be modified to 20 and 80 as well or any other level as per the analyst.

Image Source: Refinitiv, Chart analysis: Team Kalkine

Interpreting signals generated by the RSI is quite simple. Whenever RSI rises above 30 (after going below 30, as depicted by green arrow in the above chart of APT), it is interpreted as a buy signal. Similarly, when the RSI falls below 70 (after going above 70, as depicted by red arrow in the above chart of APT), it is taken as a sign of weakness and hence a sell signal.

This is the most common use of the RSI. However, with the RSI being a very versatile indicator, there are quite a few ways to interpret this indicator.

  1. Trend Identification

Although the RSI is not a trend following indicator, some analysts keep a close eye on level 50. Being the mid-point of the entire range, it also helps to figure out the current bias of direction of the security. If RSI is below 50, the trend could be interpreted as negative and above 50, a positive trend.

  1. Helps to spot divergence

Indicators which are based on price, or in other words are derivatives of price, should move in tandem with the price, which is the case most often. But sometimes the indicator does not follow the price quite precisely and tends to diverge. This disagreement between the price and its indicator is called a divergence and is often an indication of a reversal.

Image Source: Refinitiv, Chart analysis: Team Kalkine

A bearish divergence occurs when the price makes two consecutive higher highs but the indicator’s second high fails to breach its preceding high (as depicted in the above chart of Afterpay Limited (ASX:APT)). Similarly, a bullish divergence occurs when the price makes two consecutive lower lows, but the indicator fails to replicate that.

The RSI is very commonly used to spot these divergences to catch short-term tops and bottoms or to do mean reversion trading. 

  1. Failure swings

Another popular way the RSI generates an actionable signal is through a failure swing. A failure swing occurs when the RSI and price move diverge from each other. In an upswing, the price hits a new high and the RSI turns from the overbought levels. As the price surges further, the RSI fails to cross the previous peak and turns down once again. However, this time, the RSI breaks the low made during the previous swing, which is a sign of weakness. The exact opposite scenario occurs during a bearish move.

This signal is also interpreted as a reversal signal.

  1. Patterns in RSI

One increasingly popular and highly effective method to interpret RSI is to draw same patterns, trendlines, support and resistance levels etc. as being traditionally drawn in the price chart.

Image Source: Refinitiv, Chart analysis: Team Kalkine

For e.g., a trendline breakout in RSI is interpreted in the same way as a trendline breakout on a price chart with same implications (an upward trendline breakout in RSI is depicted above, generating a sell signal in the APT share). Other example could be – RSI bouncing off a strong support level, that level could be given a high relevance and may be interpreted as a sell signal if that support level gets breached. 

Ideal market conditions to use RSI

Just as with other oscillators, the RSI also requires a favourable market condition to be more effective and might not work in every market environment. Being an oscillator, the RSI works best in a rangebound market or a consolidation phase where the security is bouncing off between an established support and resistance level. This is an ideal condition to use the RSI to attempt to catch these reversal points in the range.

However, if the market or security is trending (either up or down), the RSI could easily fall prey to false signals. The simple reason being when the market is strongly trending, the RSI would penetrate the overbought/oversold zones and give a sell signal (on correction in a bull market) and a buy signal (on rallies in a bear market).

However, most of the time the corrections in a bull run are just an opportunity to buy and not to take a short call at the top. Similarly, trying to catch a bottom in a bear market, considering it as oversold, generally doesn’t pay well. Therefore, the use of RSI should be avoided during a strong trend.  

Read More: Dow Theory and History of Technical Analysis

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