Technical analysis is also the basis of analyzing the valuation of a stock along with the fundamental analysis. There are many types of models used in the technical analysis of the stocks. One such technique is the momentum oscillators that are an essential part of the technical analysis by any investor or trader. RSI or Relative Strength Index is the momentum oscillator that is used for the technical analysis of the stocks.
Given below is the meaning and the related details of the RSI Indicator.
What is a momentum oscillator?
The concept of momentum oscillator is used to indicate the price velocity or the speed with which the changes in the prices of a stock are seen. This measurement of the momentum of the stock can be understood through an example. Consider the share price of Company A to be Rs.100. If the stock price moves from Rs. 100 to Rs. 110 in a day and Rs. 120 in another, it indicates that the price of the stock has moved by 20% in mere two days. If the same stock moves approximately 10% in about a month, then we can interpret it to have low momentum.
What is the meaning of the RSI indicator?
RSI (Relative Strength Index) indicator, as mentioned above, is the momentum oscillator that was first introduced by J. Welles Wilder in 1978. This is a technical analysis indicator that shows the speed of the changes in the prices of various instruments like stocks, commodities, futures, bonds, etc. RSI indicator is widely used by traders, investors, and analysts to study the price movements and make sound investment decisions. When the percentage of price variations are plotted on a chart they form a Rate of Change (ROC) indicator.
How to calculate Relative Strength Index (RSI)?
RSI Indicator is the momentum oscillator that is used to identify the price trend reversal. The formula for calculating the RSI indicator is the difference between the average closing price on the up days and down days. The default period for analyzing the RSI indicator is 14 days.
The formula to calculate the RSI indicator is mentioned below.
|RSI = 100 – [100/ (1+ Average gains / Average losses)]|
Interpretation of RSI indicator
RSI Indicator ranges from 0 to 100. There is a basic premise to interpret the RSI indicators and understand the price movements of a stock. Traders, analysts, or investors review the RSI indicator of the stock and its movement between zero to 100.
If the RSI indicator is above 70, then the stock is considered to be overbought. On the other hand, if the RSI indicator is below 30, then the stock is considered to be oversold. This analysis helps the traders, analysts, or investors to chart an investment strategy and take a buy or sell position for the stock.
While studying the RSI indicators, it is also important to note that the RSI indicators show different indicators in bullish and bearish trends. In a bullish trend, the RSI indicator usually shifts between the range of 40 to 80 or 90. The range of 40 to 50 in the bullish trend acts as a support.
On the other hand, the RSI indicators tend to be in the range of 10 or 20 to 60 in the bearish trend. The range of 50 to 60 acts as resistance in the bearish trends. These are the usual parameters for analysis however, they are subject to change based on the strength of the underlying security or the market trend. In general, the price is considered to have an upward trend if the price is above the 50 line and a downward trend if the price is below the 50 line.
Another aspect to consider in the study of RSI indicators is the price divergence. It is the point of bend or a change in the direction of the price that can indicate the reversal of the trend. Divergence is the point where the price line and the RSI move in the opposite direction that can be identified as a potential change in the price trend.
Why is RSI important?
The points below highlight the importance of RSI indicator:
- RSI is an indicator that helps traders capture market momentum by measuring the magnitude of price fluctuations.
- Traders use RSI to recognize oversold and overbought markets and decide on when to open a position.
- RSI helps traders identify whether a stock is overbought or oversold.
- When a stock is overbought, it means that it has risen too much too quickly and may be due for a correction.
- When a stock is oversold, it means that it has fallen too much too quickly and may be due for a rebound.
What are the limitations of the RSI indicator?
There is no such thing as a full-proof strategy that can be applied to make guaranteed profits in the stock markets. Like every indicator and investment strategy, RSI indicators also have certain limitations. Some of such limitations are stated below.
- RSI indicator can send ambiguous or misleading signals that can lead to wrong investment or trading decisions.
- RSI indicator is not as helpful when the markets show a strong trend.
- There could also be a case when the RSI can move without showcasing a clear trend or stay in the overbought or oversold area for a long time. This will not help the investors or trades make a clear opinion of the possible price movement or the following trend.
RSI indicators can show the price momentum and the trends followed by the stock based on such momentum. However, it cannot be considered as a sole indicator of price velocity and predicting the price trend. Therefore, investors, traders, and analysts use many other technical tools like moving averages, candlesticks, etc. to have a better understanding of the stock price movement and the index in general.
A positive divergence is when the price line reflects a lower high and lower low as against the higher high and higher lows of the RSI.
A negative divergence is when the price line shows higher highs and higher lows against the lower highs and lower lows of the RSI.
The average or the default period used to calculate RSI is 14 days.
The ideal entry conditions based on RSI are when the moving average of the RSI is rising for the defined candles in a row and the RSI is below 70. The moving average will define a trend and the RSI below 70 will ensure that the decision to enter the market is not at the top of the trend.
The ideal condition to exit the market based on the RSI indicator is when the RSI moving average is falling in a row, the market close is lower than the trailing stop loss, and the trader has made at least a bare minimum profit before exiting the market or encountering a loss.