The relative strength index (RSI) helps identify overbought or oversold signals. A lot of times, stock price movements tend to bounce back where there are overbought or oversold conditions. RSI will give you better clarity about momentum as well.
While there are many indicators that are in use to gauge overbought or oversold conditions, a relative strength index (RSI) is one of the most used. Let us know about RSI in detail and see how you can form strategies around it.
What is the Relative Strength Index (RSI)?
The relative strength index (RSI) is a leading momentum indicator. Momentum indicators are technical analysis tools used to gauge the strength or weakness of a stock’s price. RSI measures the velocity of a stock’s directional price movement.
Here, an RSI indicator measures how strong or weak a recent price change is and through that, it gives overbought and oversold signals.
The relative strength index is also an oscillator. The RSI values oscillate between zero and 100, showing different levels of demand conditions.
The momentum oscillator was developed by J. Welles Wilder Jr., who is well-known for his works in the field of stock markets technical analysis. He introduced RSI through his book “New Concepts in Technical Trading Systems,” which was published in 1978. Both the book and the indicator still hold value even today.
RSI calculation
Calculating RSI values is simple and straightforward. Most charts will have the option to add an RSI indicator, but learning how to calculate the values will give you a better idea of how it works.
The formula for RSI calculation is –
RSI = 100 – 100 / (1 + RS)
Where RS is the profitable price closes divided by loss price closes. The indicator value is reflected as a percentage, and hence it will be between 0 and 100.
Let us understand this better with an example. For ease of calculation, let us assume the stock has profitable closes in 7 days and unprofitable closes in 7 days out of the last 14 days.
Hence, RS will be (7/14) / (7/14) = 1
Then, RSI = 100 – 100 / (1 + RS)
That is, 100 – 100 / (1 + 1) = 50
What do different RSI values mean?
As said above, RSI is an oscillator, and the value is calculated on the basis of percentage. Hence, the value will be between zero and 100.
Traditionally, this value can be used to find overbought and oversold conditions. Here, a value above 80 is usually considered overbought. The consensus here is that the stock’s price would soon hit the ceiling or threshold and would bounce back. Hence, traders can employ an appropriate strategy to make use of the information.
Similarly, a relative strength index reading of below 20 indicates oversold levels. Here, the general trend is that the stock would start to rise again after hitting a threshold. Here, too, traders can employ a strategy accordingly.
For instance, in the above example we used during calculation, the RSI value was 50. This neither shows oversold nor overbought readings, but it is closed to oversold levels than overbought readings. RSI gives you this reading by calculating the velocity of price movements, as we have seen above.
But RSI holds more information than what is seen on the surface level. It is often used with a combination of other indicators to form sound strategies.
Also, an oversold or overbought reading doesn’t always mean immediate trend reversal. You may have to use other technical analysis tools and keep an eye on the price chart closely here. It could sometimes be an indication to exit your current positions as well.
RSI in a chart
Above is a price chart of Nifty 50 on a particular day. Below that, you can see the RSI chart. Here, the black line is the RSI line. As we have discussed above, the same oscillates between zero and 100. You can see points 80 and 20 marked in the graph because they are deemed important in assessing overbought and oversold conditions.
Forming trading strategies with RSI
The best use of any technical indicator is when you are able to formulate winning strategies from it. A relative strength index can also be used, sometimes along with other technical indicators, to form strategies. Let us take a deeper on the same and how certain combinations with other technical analysis tools could help your RSI trading strategy.
Finding overbought or oversold levels
The primary and the most basic use of the RSI indicator is to find overbought and oversold levels. Let us see how it works.
Theoretically speaking, the level at which a stock enters the overbought territory is when it touches the 80-level mark on the RSI indicator. Above is a price and RSI graph of TCS on a particular time period. Pay attention to the area in the graph marked by the crosshairs. Here you can see the RSI line has touched the 80-level mark, indicating a clear overbought scenario. Shortly once that happened, you can see the green candles diminishing and the price doing down, proving the indicator right.
Here, as a trade, you can employ a strategy accordingly. For instance, you buy the stocks of entering a long position here to make the best out of the information.
Now, let us look at the contrary of this.
Above is the price and RSI graph of TCS from another occasion. Here, you can see that the RSI line breaches the lower 20-level mark, signalling oversold conditions. The stock movement immediately proves RSI right by showing an uptrend.
RSI lines are used to gauge overbought and oversold readings in both bull market and bear market. But that doesn’t mean it always shows the right signal. Take a look at the below graph.
Here, at the point marked with the crosshair, it can be seen that the RSI has clearly breached the upper limit, signalling severely overbought conditions and still, the price kept going up.
Hence, the best course of action is to, instead of blindly trusting signals from an indicator, confirm the information with another indicator and gauge the current market and economic situations before making a decision.
Bullish divergence
The divergences in the RSI and price chart can also give trade signals. Let us take the example of a bullish divergence first.
A bullish divergence is noted when the RSI indicator marks an oversold reading below 20, followed by a higher low that corresponds with the lower lows in the price chart. This could indicate a bullish divergence. When a bullish divergence occurs, the market could go up considerably. Below is what a bullish divergence would look like in the graph.
Bearish divergence
A bearish divergence occurs in RSI when the opposite to the above situation happens. Here, the RSI lines do an overbought reading above 80 and, after that, make a lower high that matches corresponding higher highs on the price chart. This is considered a sell signal, and you could sell or enter a short position to make the best out of the information.
RSI Bullish Failure swings
You can also find trade signals by looking at how the RSI indicator behaves when recovering from an overbought or oversold level. These are called failure swings.
A bullish failure swing forms when the RSI goes below the 20-level mark. It then comes back to go above 30, then forms another dip coming back into the oversold territory and finally breaking its most recent high. Below is a pictorial representation of the same.
You could enter a trade or open a long position at the fourth point market in the RSI graph above to use the information beneficially.
RSI Bearish Failure swings
Bearish failure swing forms after the price have gone to the overbought territory. Here, the price has to cross back below 70 after hitting the overbought territory first. Then, it bounces back and forms another high in the overbought territory. After which, it breaks its most recent low and to march into bearish territory. The below pictorial representation may help you understand the same better.
Here, too, the fourth point is an ideal point to take action.
Trend lines with RSI
A trendline is drawn between two or more pivot points to better understand the price behavior of security. An RSI indicator can be used to draw trendlines as well,
Here, if you are dealing with a bull market and you need to draw an RSI uptrend line, you could start by connecting three or more points on the RSI line when it is rising.
On the contrary, a trendline that is going downwards can be drawn by connecting three or more points on the RSI line as goes down.
Here, when an RSI trendline breaks, it could indicate a trend reversal or price continuation.
RSI vs Stochastic indicator
Both RSI and stochastic indicators are primarily used to gauge the overbought and oversold levels. But the way they work is different. RSI indicator gauges the strength of the price by looking at the velocity of the price movements, while a stochastic indicator looks at similar patterns in the past to give you the results. Here, stochastic could work better in choppy markets while RSI favors trending markets.
RSI vs MACD – which is better?
Moving average convergence divergence (MACD) is another technical indicator used to gauge overbought and oversold readings.
The MACD indicator looks at the relationship between two EMAs, while the RSI measures a price change in relation to recent highs and lows.
Here, too, both are better in different scenarios. But overall, different studies have shown that RSI tends to give lesser false signals compared to MACD. At the same time, MACD is more versatile – it can be used to gauge trading signals in wider and more different timeframes. MACD also produces more frequent signals than RSI.
Combination of RSI and MACD
RSI can be used as a trend-confirming tool for MACD and vice versa. When both the indicators agree on a signal, the chance for it to be false tends to decrease. Similarly, when both indicators are not agreeing on a signal, the chance for false signal increases.
Advantages of RSI
The biggest advantage of an RSI indicator is that it is easy to understand and implement. Often, technical indicators could become overwhelming due to their complexities in implementation and calculation. RSI has an advantage here as it could be easy to calculate and interpret.
Another plus point of RSI is that it could work in non-trending zones as well. This could work in favour of traders as most indicators work the best when the market is trending.
RSI also help you find the key reversal levels. This information could be immensely useful for the traders to set entry points. You could increase the level of trustworthiness of the information by conforming with another indicator.
Lastly, there are many indicators that signal momentum changes, but RSI is also helpful in identifying low-momentum or loss of momentum.
RSI limitations
The biggest con RSI has is one that it shares with most similar indicators. It could indicate false signals at times, especially in a highly trending market.
Another disadvantage is that RSI values are not volume-backed. It means that it completely ignores volume, and this increases the probability of erroneous signals during a low-volume period.
Bottomline
RSI is one of the oldest yet most used indicators out there. The success of trading strategies may heavily depend on the timing and how you manage to use it alongside other indicators to gauge trading signals.
FAQs
Do overbought and oversold readings in RSI mean sudden trend reversal?
Not always. RSI is best used when seen as an indicator that gives you a signal to be ready to face a trend change. The best practice is to use another indicator to confirm the trend before making a move.
Which is better – RSI, MACD or stochastic?
These three indicators gauge market momentum but use different techniques. For instance, MACD looks at the difference between two EMAs, while RSI measures a price change with respect to its highs and lows. Hence, the different indicators could prove to be beneficial in different conditions.
