What is Relative Strength Index?
RSI is one of the most popular technical analysis indicators. Relative Strength Index (RSI) is an oscillator that measures current price strength in relation to previous prices. The RSI is a versatile tool, it can be used to:
- Generate buy and sell signals
- Show overbought and oversold conditions
- Confirm price movement
- Warn of potential price reversals through divergence
RSI Calculation -
The steps in calculation of the Relative Strength Index are:
- Decide on the RSI Period, based on the time frame that you wish to analyze.
- Compare Closing price [today] to Closing price [yesterday].
- For the RSI Period, add all upward movements in Closing price.
- For the RSI Period, add all downward movements in Closing price.
- Calculate the exponential moving average* of price movements:
Average Upward Price Move = Exponential Moving Average of Upward Movements
Average Downward Price Move = Exponential Moving Average of Downward Movements - Calculate Relative Strength (RS):
RS = Average Upward Price Move / Average Downward Price Move - Calculate the Relative Strength Index (RSI):
RSI = 100 - 100 / ( 1 + RS )
Interpretations -
- Tops and Bottoms.
The RSI usually tops above 70 and bottoms below 30. It usually forms these tops and bottoms before the underlying price chart.
- Overbought/oversold levels: The RSI value will always move between 0 and 100; the value will be 0 if the stock falls on all 14 days, and 100, if the price moves up on all the days). This implies that the RSI can also be used to identify the overbought/oversold levels in a counter. As suggested by J Welles Wilder, the developer of this indicator, most technical analysts consider the RSI value above 70 as 'overbought zone' and below 30 as 'oversold zone'.
- Failure Swings.
(also known as support or resistance penetrations or breakouts). This is where the RSI surpasses a previous high (peak) or falls below a recent low (trough).
- Support and Resistance.
The RSI shows, sometimes more clearly than price themselves, levels of support and resistance.
- Divergences.
Divergences occur when the price makes a new high (or low) that is not confirmed by a new high (or low) in the RSI. Prices usually correct and move in the direction of the RSI. A positive divergence occurs when the RSI makes a higher bottom despite lower trending by share price. Similarly, a negative divergence occurs when the RSI starts falling and makes a lower top despite the share price moving higher.
A bullish divergence occurred during May and June as prices were falling while the RSI was rising. Prices subsequently corrected and trended upward.
Significance of RSI
- The relative strength indicator (RSI) measures the relative strength or weakness of a stock when it is compared to itself over a specified period. It is an OSCILLATOR with an upper and lower band that ranges from 0 to 100 on a vertical scale.
- To understand the RSI, we need to know what is meant by Relative Strength and Relative Weakness, two of the most important concepts in technical analysis. Relative strength means that a stock is strong compared to another stock or to an index. Generally, you avoid buying stocks with relative weakness.
- When used in conjunction with other technical indicators such as moving averages and OBV, the RSI is a powerful tool that can help to identify whether a stock is OVERBOUGHT or OVERSOLD. This allows you to determine which stocks are going to run out of energy and succumb to the bears (overbought). On the other hand, the RSI will also help you to identify stocks that have fallen and are about to reverse and move higher (oversold).
For example, if the stock price is dropping, but the RSI rises above 70 and then crosses back down, this is a sign that the stock might reverse direction (this price reversal is called DIVERGENCE). Conversely, if the stock price is rising, but the RSI drops below 30 and crosses back up, the stock might reverse. The idea is that the stock price will eventually move in the direction of the RSI.
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