In the technical analysis arena, momentum trading indicators have often been used by professional traders to maximise profit for an extended period of time. Here in this piece of work, we will discuss the Relative Strength Index (a family member of momentum indicators, and how it could be intelligently used to benefit from trading activities.
The Relative Strength Index (RSI) is the part of the various momentum indicators. Other momentum indicators are MACD, ROC etc. A momentum indicator measures a rate of change in an underlying and can be graphically plotted on a scale of 0 to 100. This scale helps in understanding the ultra-conditions like overbought or oversold with regards to the price actions in an underlying security.
The Relative Strength Index helps in understanding the velocity and volume of price volatility and helps in representing them by moving between the range of 0 to 100.
The RSI of a security X can be calculated as follows:
Relative Strength (RS) of X = Average Prices of positive closing trading days of X * Average Price of negative closing trading days
Relative Strength Index = 100-100/(1+RS)
Overbought and Oversold Zones
Now that we know, how to calculate RSI of an underlying security, let us first understand the uses of RSI indicator to benefit from your trade.
The most common interpretation of the RSI is the overbought and oversold territory of the RSI. A level above 70 on RSI scale is generally considered that a stock is hovering in overbought territory and a move below 30 implies an oversold zone. An oscillation of RSI level near 50 is deemed to be a neutral area and should be looked carefully.
Therefore, when RSI moves above 70, it indicates that the market is overheated, and one should consider going short, as a potential reversal is very imminent. And, on the other hand, a move below 30 reflects that the market has been oversold, and traders should go long as a potential upside reversal is very much on the cards.
Further, an upward movement, just above the 30 reference line should be considered as a bullish indicator, and a downward move just below the 70-reference line should be considered as a bearish indicator and trade should be placed in those indicated directions.
Also, the best use of RSI indicator is when prices are hovering in a sideways direction and not showing any steep bullish or bearish trend. Moreover, RSI should be considered as a secondary indicator by traders and not as a primary indicator.
Market Technical experts state that when the price of underlying security hits the upper trading band and the RSI oscillator above the reference point of 70, it shows signs of weakness and traders should judiciously watch this as reversal of the current uptrend and should use this signal to book profit or to go short. And on the other hand, when prices hit a lower trading band, and the RSI oscillator hovers near the reference point of 30, traders should use this signal to book profit and cover their short position or go long.
Note: in this piece of work, we have used long and short terminology multiple times. The long position implies bet on the potential upside movement in the scrip, and Short means bet on the potential downside movement in an underlying. An underlying could be an index, stocks, currency, commodity, and many others.
Identify Price Divergence with the use of RSI
Price divergence should be watched sensibly as they are important reversal indicators and are used extensively by the trading community and chartist across the world to enter into a trade before anyone else come to understand that a reversal trend is in place. A price divergence is considered as a leading indicator to gauge any reversal from the prevailing price trend.
Let us understand two types of divergence that are possible to be figured out by using the indicator of the RSI:
- Bullish Divergence: A bullish divergence occurs when the price of an underlying hit a lower low but at the same time Relative Strength Index oscillator hits a higher high. This indicates that the bottom for an underlying is in place, and buyers are steering the momentum now, and a potential upside movement is possible in the medium term.
(Source: Thomson Reuters)
Let’s understand by an example- here, in the above chart, we can see a small-bullish divergence, as the stock was hitting new lows but RSI oscillator registered a reversal and was moving higher towards the neutral zone, this reflects that stock forms support near 2000 price level and then momentum shifts towards the buyer.
- Bearish Divergence: A bearish divergence is one when an underlying hit a higher high but RSI oscillator hits a lower low, which indicates that momentum is shifting in favour of bears or short-sellers and also one can use this indicator to book profit from his/her open long position to maximise returns.
(Source: Thomson Reuters)
In the above example, we can see that stock price was moving higher, but at the same time, RSI registered a reversal trend.
However, one should also remember that divergence could also be misleading if the stock is in strong trend, either bullish or bearish. Therefore, one needs to remain cautious while using Price-RSI divergence, especially in the case of naïve traders.
Also, it is vital for traders to understand that Relative Strength Index could potentially be a very good indicator in a ranging market, but in trending market, it might not be of that use. For example, in an uptrend market the RSI oscillator might oscillate between 75-80 on the upside and 40-35 in the downside. This implies that any move below 40 or 35 should be considered as strong bullish reversal and should go long. And, on the other hand, any move above 75-80 should be considered as an overbought signal and should be used to book profit or go short.