A comprehensive guide to understanding and using the relative strength index (RSI)

The Relative Strength Index (RSI) is a technical analysis indicator used by traders and investors to analyse the price trends of stocks. It measures the speed and magnitude of a security’s recent price changes (how rapidly and by how much they have been rising or falling). This in turn can help identify overbought and oversold conditions in the financial markets. Read on to learn how using the RSI indicator can help you make investment decisions and enhance your overall understanding of the markets.

• Table of contents

1. The basics of the RSI indicator
2. Steps to calculate the relative strength index
3. How the relative strength index functions
4. Interpreting RSI readings
5. Exploring RSI divergence: What it means for traders
6. Understanding RSI convergence and its implications
7. Why the RSI indicator is important for traders
8. Limitations of the RSI indicator

The basics of the RSI indicator

The Relative Strength Index is a momentum oscillator developed by J. Welles Wilder and introduced in his 1978 book New Concepts in Technical Trading Systems. The RSI calculates the magnitude of recent price changes to analyse and forecast the momentum in the market.

The indicator values fluctuate between 0 to 100. RSI is commonly used to identify overbought and oversold conditions and divergence from the price action. In simple words, it helps determine when an asset's price may have risen or fallen too far and is due for a reversal.

The main function of the RSI is to compare the size of recent gains versus recent losses in an asset over a set period of time. The relative strength metric measures the strength of the gains versus the losses. The index then converts this ratio into a smoothed oscillator that moves between 0 and 100.

Generally, when the RSI is above 70, it may indicate overbought conditions and an RSI below 30 may indicate an oversold stock.

Some traders may adjust these levels to be less extreme (such as 80 and 20) or more extreme (such as 90 and 10) based on their trading style and market.

Steps to calculate the relative strength index

The RSI calculation process involves these main steps:

1. Calculate the average gain and average loss over a certain period. The default time period is 14 periods.

2. Calculate the relative strength (RS) by dividing the average gain by the average loss.
RS = Average gain / average loss

3. Calculate the RSI using this formula:
RSI = 100 - (100 / (1 + RS))

The RSI formula essentially takes the relative strength ratio and converts it into an oscillator that fluctuates between 0 and 100.

As the average gains rise compared to the average losses, the RS and RSI values move higher. When losses outweigh gains, the RS and RSI values move lower.

How the relative strength index functions

The working and interpretation of the RSI are based on these key principles.

• The RSI values range from 0 to 100.
• A reading of 70 or above indicates an overbought condition.
• A reading of 30 or below indicates an oversold condition.
• Values between 30 and 70 show neutral momentum and no clear overbought or oversold signals.
• When the RSI crosses above 30 from below, it is considered a bullish signal and an uptrend may follow.
• When the RSI crosses below 70 from above, it signals a bearish move and a downtrend may follow.
• Divergence occurs when the price trends in one direction but the RSI trends in the opposite direction, signaling a potential trend reversal.

Interpreting RSI readings

• Readings between 0 and 30 mean the asset is oversold. The asset is considered undervalued by the market. Upside momentum may build.
• Readings between 30 and 70 indicate neutral sentiment. No overbought or oversold signals.
• Readings between 70 and 100 mean the asset is overbought. It may be overvalued and due for a reversal. Downside momentum may build.
• Readings at or above 80 signal a strong overbought condition. A reversal is likely, but no precise timing known.
• Readings at or below 20 signal a strong oversold condition. A reversal is likely, but no precise timing known.
• As a general rule, when the RSI reaches over 70, traders consider it better to sell or avoid new long positions. When it drops below 30, it may present buying opportunities or closing short trades.

Exploring RSI divergence: What it means for traders

RSI divergence is when the Relative Strength Index moves differently than the stock price. This can signal a potential trend reversal.

There are two types of RSI divergence:

Bearish divergence - Price makes a higher high while RSI forms a lower high. This shows upside momentum is slowing down as buyers get exhausted. It signals a potential bearish reversal.

Bullish divergence - Price makes a lower low while RSI forms a higher low. This shows downside momentum is decreasing as sellers get exhausted. It signals a potential bullish reversal.

Spotting RSI divergence can help traders anticipate and potentially take advantage of the expected trend reversal. However, instead of using it as a standalone metric, divergence should be confirmed with other signals like volume and moving average crosses.

Understanding RSI convergence and its implications

Convergence is the opposite of divergence. It means that the RSI is moving in sync with market prices, confirming the prevailing trend.

This means that when the price chart makes higher highs, the RSI also moves to a new high, showing upside momentum and indicating an uptrend. Similarly, when the price drops to a lower low, the RSI makes a lower low too, confirming a downtrend and bearish momentum.

Unlike RSI divergence, which signals a potential reversal, convergence reinforces the strength and validity of the current trend.

Why the RSI indicator is important for traders

The RSI indicator can be a helpful tool to assess market conditions and opportunities. Here’s how”

• Helps identify overbought and oversold conditions and potential reversal points.
• Warns when an asset may have been overbought and is due for a price correction.
• Informs when an asset may have been oversold and could bounce back.
• Confirms trends when RSI converges with the price action.
• Signals potential trend reversals through divergence before the price changes direction.
• Works on all markets and timeframes from 1-minute charts to monthly.
• Easy to interpret with clear overbought/oversold threshold levels at 70 and 30.
• Provides an objective momentum measure to complement other subjective indicators.
• Simple and fast to calculate with most charting platforms offering RSI as a standard indicator.

Limitations of the RSI indicator

The RSI should be used in conjunction with other indicators and metrics. Here are some of its drawbacks:

• Does not indicate precise entry, exit or stop loss levels. Needs to be combined with other tools.
• Can remain in overbought or oversold zones for extended periods during strong trends.
• Divergence does not always lead to immediate reversal. Requires confirmation.
• Prone to giving false signals in choppy or range-bound markets.
• Default overbought/oversold levels may need to be adjusted for different instruments and timeframes.
• Works better when used with other confirming indicators like moving averages, candlestick patterns and volume.
• Not advisable to use RSI in isolation to make trading decisions. Combine it with price action analysis.

Conclusion

The Relative Strength Index is a versatile momentum oscillator that can help assess whether an asset is overbought or oversold. It can also help investors spot potential trend reversals.

RSI values above 70 signal overbought conditions while values below 30 indicate oversold conditions. Using the RSI together with chart patterns and other indicators can help traders spot opportunities. However, the RSI alone should not be relied on completely to make trading decisions. It can be suitable to indicate trade signals and provide additional context to price action.

FAQs:

What is the Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a momentum oscillator that measures the magnitude of recent price changes to analyse overbought or oversold conditions. It fluctuates between 0 to 100. RSI above 70 signals an overbought asset while RSI below 30 indicates an oversold asset.

How is the RSI calculated?

The RSI calculation involves taking the average gain and average loss over a period, finding the relative strength by dividing the average gain by the average loss, then converting that into an index between 0 and 100 using this formula:

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

(Where RS is the relative strength ratio. The default RSI time period is 14 periods.)

How is RSI used in trading?

Traders mainly use the RSI to identify potential reversal points in the market when an asset is overextended and due for a correction. RSI levels above 70 indicate overbought conditions and signal potential selling opportunities while levels below 30 indicate oversold conditions and potential buying opportunities.

What are the typical RSI levels for overbought and oversold conditions?

A reading above 70 indicates the asset may be overvalued and is a potential sell signal. A reading below 30 indicates the asset may be undervalued and is a potential buy signal.

Some traders use 80 as the overbought threshold and 20 as the oversold threshold to be more conservative. More aggressive traders may use 90 and 10 as levels. The levels can be adjusted based on the instrument and timeframe.

What are the limitations of using the RSI?

The RSI does not provide specific entry or exit points, can remain in overbought or oversold zones for extended periods, and divergence does not guarantee an immediate trend reversal.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.