What is the Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a popular technical indicator that traders typically use to measure the momentum of a price movement of an asset.

RSI does it by evaluating the speed or rate of price movement of an asset and relays an indication in figures between 0 and 100.

Skilled traders, by employing solid strategies powered by such indicators, might even make up to INR 1 lakh in profit. Therefore, if you are a trader and want to capitalise on profit-making opportunities, read this blog to learn about RSI.

What Does the Relative Strength Index Indicator (RSI) Mean?

Developed by J. Welles Wilder, an RSI indicator works as a momentum oscillator which helps you, as a trader, to estimate the speed and magnitude of price changes of your favoured assets.

By indicating this rate or speed of price change, you can determine whether the asset under tracking is being oversold or overbought.

To generate the indication, the Relative Strength Index (RSI) uses a specific formula where it calculates the relative strength based on its average gain over a specified period and divides it by the average loss over the same timeframe.

Typically, an RSI indicator uses a lookback period of 14 days in terms of the specified period. The applicable formula here becomes:

RSI = 100 – [100 / {1 + (Average of gains over the period / Average of losses recorded over the period}].

While using this formula to determine an indication by placing the specific information, you can estimate overbought or oversold signals. For example, in an RSI, a signal or reading above 70 shows an overbought condition. Conversely, an RSI signal below 30 indicates an oversold condition.

Furthermore, if the signal from this indicator is at 50, it signals a balance between bearish and bullish sentiment, indicating a neutral stance.

How to Calculate Relative Strength Index (RSI)?

As you already noted, the average look-back period in an RSI calculation is 14 days, and depending on it, average gains and losses over 14 days, it produces specific signals.

You must also note that this formula considers losses as positive figures. Also, during this period, the price losses are taken as having a zero gain on average. Conversely, for price increments, it considers the asset accumulating zero average losses.

To better understand this RSI calculation, have a look at the following hypothetical example:

Suppose, during a look-back period of 14 days, a stock closes at its high for 7 days and makes an average gain of 2%. For the rest of the 7 days, it has closed recording lows, making an average loss of -0.7%. To get an indication from this trend, let’s impose these data:

RSI = 100 – [100/ {1 + (2% /14) /(0.7%/14 )}] = 74.074.

Depending on the RSI indication, this value therefore shows an overbought or an overvalued condition signalling you as a trader to take a selling position.

With PL Capital Group – Prabhudas Lilladher, you can trade in stocks, invest in IPOs, mutual funds and more. Download the PL Capital app, create a Demat account and start investing!

How to Interpret an RSI Indicator?

Now that you know the relative strength index meaning and RSI calculation, you must also have a clear idea about how to interpret it for making informed trade decisions. Here is a detailed view:

1. Decode the Strong Trends

   Typically, during a bullish market sentiment, the RSI of a stock might go beyond the level of 70. If it stays at this level for an extended time, it indicates a potential overbought situation. If such a situation persists, this value can be adjusted further to 80, showing a stronger trend.

2. Read From Other Indications

   An RSI indicator typically provides more indications, such as double tops or double bottoms, to provide a bit more information on the price trend. Suppose a stock price has made a lower low recently. Its RSI may form a double bottom near 30. This indicates that average losses might not increase further, and a chance of an upward breakout might be near.

3. Get the Idea on Support and Resistance Levels

   While interpreting insights from an RSI, you can determine support and resistance levels of the concerned stock. For example, during a bullish market, when the RSI is between 40 and 90, the zone between 40 and 50 acts as a support zone. Conversely, in a bearish market, the RSI being between 10 and 60, the region from 50 to 60 indicates a resistance level.

What is RSI Divergence?

With the Relative Strength Index (RSI) comes the concept of divergence. A divergence might occur, especially when the RSI of an asset is not aligning with its price movement. Two types of divergences that you must note here are positive and negative divergence.

1. Positive Divergence of RSI

   A positive divergence happens when an RSI indicator shows higher lows, but the asset price is hitting its lower lows. This indicates a potential reversal from an oversold situation of an asset.

   Suppose a stock price falls from INR 102 to INR 98, but the RSI reading at this new low is 32. However, reading during the last low was 28. Thus, it shows momentum is strengthening even though the price is falling, hinting at a possible reversal.

2. Negative Divergence of RSI

   Quite opposite to positive divergence, a negative divergence takes place when the RSI of an asset generates lower highs, but the asset price creates higher highs. It signals a possible reversal from an overbought condition.

   Suppose a stock price rises from INR 150 to INR 156. However, the RSI falls to 68 from 72. It shows that its bullish momentum is weakening, although recording a new high.

What is Relative Strength Indicator (RSI) Convergence?

Another insight from an RSI indicator that you must note during a bearish market is RSI convergence. It typically happens when asset prices are falling, but it is near the end of a downtrend.

It therefore indicates a potential reversal in price trends, indicating that the asset’s value might rise soon. Plus, an RSI convergence typically appears before the price actually starts going up.

However, the appearance of a convergence alone does not always guarantee a price uptrend. Hence, as a trader, you must make a market entry with caution if you are following this indication.

Advantages of Using RSI in Trading

Before you use RSI while trading, you must also note some of its key advantages. Noting these advantages might help while utilising its functionality better while trading in the stock market:

1. Acts as a Confirmational Tool

   As a trader, you can use the Relative Strength Index (RSI) while trading as a confirmational analysis tool. For example, alongside candle, bar or line charts, you can use an RSI signal to confirm the price trend that such charts are showing.

2. Versatility Across Asset Types

   Another key advantage of this indicator is its usability across different sorts of assets. Thus, it helps you to confirm trends of multiple asset types. You can use it to confirm the price trends of stocks, indices, commodities, forex and assets with price data.

3. Easier to Interpret

   Being an indicator, RSI is simpler to interpret for traders as it signals overbought or oversold conditions within a range of 0 to 100. For example, both beginner and experienced traders can understand that an RSI of over 70 is an overbought signal and below 30 is an oversold signal.

A Few Key Disadvantages of RSI

Aside from noting its key advantages, you must also have clarity about some of its limitations. It will help steer clear of making wrong decisions due to such disadvantages:

1. Chances of Making Premature Entry or Exits

   Although it is a preferred indicator by traders, especially during strong price trends, there are chances of it generating false signals. Due to false overbought or oversold signals, you might end up entering or exiting the market prematurely.

2. Lagging Indicator

   Similar to other technical tools, RSI also generates signals for price trends based on past price data of assets. Thus, there is a chance that an RSI signal might be a bit behind the original market movement at a given point in time.

3. Does not Consider Trade Volume

   As a technical indicator to produce signals regarding price trends, it usually focuses on price changes. It does not consider the respective trade volume. Therefore, while using RSI to confirm a trend, you must also analyse trade volume to make market entry or exit decisions.

Conclusion

The Relative Strength Indicator (RSI) is considered a tool that usually generates potentially efficient signals of an asset being overbought or oversold. With its indicators, as a trader, you can estimate the market momentum and make a decision for market entry or exit.

With PL, secure your financial future by investing in mutual funds, gold bonds, stocks, etc. Download the app from the Play Store or App Store today and start investing!

FAQ’s on the Relative Strength Index

1. What is a relative strength index used for?

You can use the RSI as an indicator to estimate an overbought or oversold condition of an asset. You can use it as a confirmation tool for price trends that you derive from technical charts and make an entry or an exit from the market.

2. Which RSI value is best to buy?

A Relative Strength Indicator (RSI) signal of below 30 highlights an oversold condition. It means you might make a buying decision when you see RSI indicating below 30.

3. Is a higher or lower RSI better?

There is no better signal in an RSI, as its signal range depicts whether you should make a buy or sell decision, depending on the price momentum of an asset.

4. What is the 70 30 rule in RSI?

The 70 30 rule in RSI signals the respective overbought or oversold situation of an asset. An RSI over 70 means an asset is overbought, and you might take a selling position. While 30 indicates an asset is oversold, suggesting a potential buying opportunity.