Relative Strength Index (RSI) is a momentum indicator used to determine how frequently and up to what extent price changes are happening. And determining the extent of price changes, helps us to locate over-bought and over-sold zones. Usually, RSI is capped between 30 to 70, below which is the over-sold zone and above which is the over-bought zone respectively.
Today in this article, we are going to talk about the RSI, relative strength index. We will be covering all other terms related to it such as over-bought zone, over-sold zone, bullish and bearish divergence, and how to comprehend this indicator.
There are many popular indicators that we also have described in our various guides including options trading strategies, and candlestick chart patterns.
Understanding The Idea of Relative Strength Index (RSI)
Before proceeding I would like to mention one thing these indicators only give a generic idea of market movement, not the exact behavior. It does not give you a confirmation, it only indicates to you about price movement.
If you understand this, then you should keep in mind that you should not use only one indicator, you should see on the set of indicators. And finally the most important is price action, you can’t ignore support and resistance even after seeing the indicator. First of all, let us take a look at how the Relative Strength Index looks on a live technical chart. Just give it a glance through, we will discuss its properties in the later section of this article.
See, RSI here in the above image, because after that we are going to talk about its basics, so the RSI you are looking at and you can see the range of its value, the yellow range you can see. The first thing to know about it is that RSI is between 0 to 100, 0 is down and 100 is an upside, so it remains between zero to hundred (here the range is adjusted manually).
How To Add RSI to Your Technical Chart?
First, let me walk you through how you will put the RSI on your technical chart. I am going to use the technical chart provided by TradingView. You will click on the indicators simply and you will write RSI in the search box and a menu will appear. In this menu, you can change its settings, and adjust the values of range accordingly.
Reading & Comprehending RSI on Technical Chart
Generally, you will observe that the upper limit in the default settings is 70 and the lower limit is 30. Now if price movement is not making any significant movement and staying within the RSI, then you will need another indicator for the price prediction because in that case, this indicator won’t help you much. You should trade when you see the value going up from the upper and lower limits.
Now we come to the interpretations of the RSI indicator. What does it mean on a technical chart?
When you see the price going below the lower limit towards 0, it means the stock is in the oversold zone. Similarly, when you see the price going above the upper limit towards 100, then it means the stock is in the overbought zone.
Now, You understand that overbought means it is bought too much. But Buying too much doesn’t mean it will come down unless it creates resistance and comes down again. So when it comes down from the resistance, then there can be a recession.
Similarly, when the stock is in an oversold zone, it will not revert back until it touches a support line. When this happens, that will be the point where you can consider buying the particular stock but not before that.
Now the question arises, how to identify such a moment when the prices will reverse? Here in such a scenario, you should look for a double top or double bottom pattern. You can study about these patterns in detail on our candlestick patterns explanation!
The Formula Behind Calculating RSI
RSI is calculated on the basis of two formulas, the first formula is:
RSI =100−[100/(1+{Average gain/average loss})]
The average gain or loss in this calculation refers to the average percentage change during a look-back period. The formula treats the average loss as a positive value. When calculating the average gain, periods with price losses are counted as zero, and when calculating the average loss, periods with price increases are counted as zero. Typically, the initial RSI value is calculated over 14 periods.
For example, if the market closed higher on seven of the past 14 days with an average gain of 1%, and closed lower on the remaining seven days with an average loss of -0.8%, this is how the initial values would be determined.
55.55=100−[100/(1+{(1%/14)/(0.8%/14)})]
Then the second calculation is done to smooth the results so that the RSI only nears 100 or zero in a strongly trending market.
RSI=100−[100/(1+{[Previous Average Gain*13+Current Gain]/[Previous Average Loss*13+Current Loss]})]
I know the equations are a bit more technical to comprehend but when you will note it down on a copy or e-notes it will look much simpler.
Having said that, now let us talk about why shouldn’t you use RSI as the only indicator.
Why You Should Not Use Relative Strength Index As Only Indicator?
Some people only use RSI but that is the wrong practice because there is something we call Diversions. Let us discuss that too. One is bullish Diversions and the other is bearish diversions, now what the diversions say, you see the price of the stock going up, making an elevation on the chart. But you see that RSI is going down. When such a scenario is made, then it is not a bullish Divergence but a bearish diversion. Why? Prices will fall in this case which is an indication that bears are in control of the market. F
When this case reverses, then it is known as a bullish diversion.
When you see that the price is coming down, but from here RSI is going up, then the price will go up, then it is your bull.
So, that’s pretty much about the Relative Strength Index (RSI). Now take up any stock and use RSI in it, but do not just trade in it. If you trade only on RSI then you can make mistakes.
Wrap Up
You can also use Relative Strength Index indicators before investing in any stock to know its performance in recent times. Knowing performance helps you to decide what potential it holds. But again, do remember to supplement your knowledge and application of indicators with other indicators and financial reports that you receive.
Furthermore, we will be uploading several such indicators with detailed explanations. So stay tuned and if you have any queries do post them in the comment section, our experts will answer with the best of their capabilities.