What is RSI:Relative Strength Index ?

What is RSI?

RSI stands for Relative Strength Index. It is a momentous oscillator used to identify trend reversal.

The relative strength index (RSI) is a momentum indicator developed by noted technical analyst Welles Wilder, that compares the magnitude of recent gains and losses over a specified time period to measure speed and change of price movements of a security. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset.

RSI indicator oscillates between 0 and 100, and based on the latest indicator reading, the expectations on the markets are set.

The term “Relative Strength Index” can be a bit misleading as it does not compare the relative strength of two securities, but instead shows the internal strength of the security. RSI is the most popular leading indicator, which gives out strongest signals during the periods of sideways and non trending ranges.

What is concept of RSI?
 RSI calculates strength of stock trend and helps to predict their reversals. RSI value oscillates between 0 to 100. As per Wilder when RSI value is above 70 its is considered as overbought and when RSI is below 30 it is considered as oversold. Some traders use 75/25 or even 80/20 to define overbought and oversold.

A value between 35 to 65 is a no entry or exit point for traders who rely on RSI as primary indicator. However their movement can help supplement other indicators signal. Another use of RSI is to determine divergence between price and RSI.
Divergence indicates trend reversals.

Divergence:

A divergence is formed when

a. In a downtrend RSI is making higher high and higher lows while price is making lower high and lower lows.

b. In a upward trend RSI is making lower high and lower lows while price is making higher high and higher lows.

Uses of RSI

1.Identify overbought stocks.

2.Identify oversold stocks.

3.Identify trend reversals.

4.Identify direction of the trend .

5.Excellent tools for swing traders .

The formula to calculate the RSI is as follows:

Let us understand this indicator with the help of the following example:

Assume the stock is trading at 99 on day 0, with this in perspective; consider the following data points:

Sl No	Closing Price	Points Gain	Points Lost
01	100	1	0
02	102	2	0
03	105	3	0
04	107	2	0
05	103	0	4
06	100	0	3
07	99	0	1
08	97	0	2
09	100	3	0
10	105	5	0
11	107	2	0
12	110	3	0
13	114	4	0
14	118	4	0
Total		29	10

In the above table, points gained/lost denote the number of points gained/lost with respect to the previous day close. For example if today’s close is 104 and yesterday’s close was 100, points gained would be 4 and points lost would be 0. Similarly, if today’s close was 104 and previous day’s close was 107, the points gained would be 0 and points lost would be 3. Please note that, the loses are computed as positive values.

We have used 14 data points for the calculation, which is the default period setting in the charting software. This is also called the ‘look-back period’. If you are analyzing hourly charts the default period is 14 hours, and if you are analyzing daily charts, the default period is 14 days.

The first step is to calculate ‘RS’ also called the RSI factor. RS as you can see in the formula, is the ratio of average points gained by the average points lost.

Average Points Gained = 29/14

= 2.07

Average Points Lost = 10/14

= 0.714

RS = 2.07/0.714

= 2.8991

Plugging in the value of RS in RSI formula,

= 100 – [100/ (1+2.8991)]

= 100 – [100/3.8991]

= 100 – 25.6469

RSI = 74.3531

As you can see RSI calculation is fairly simple. The objective of using RSI is to help the trader identify over sold and overbought price areas. Overbought implies that the positive momentum in the stock is so high that it may not be sustainable for long and hence there could be a correction. Likewise, an oversold position indicates that the negative momentum is high leading to a possible reversal.

Take a look at the chart of Cipla Ltd, you will find a lot of interesting developments:

To begin with, the red line below the price chart indicates the 14 period RSI. If you notice the RSI’s scale you will realize its upper bound to 100, and lower bound to 0. However 100 and 0 are not visible in the chart.

When the RSI reading is between 30 and 0, the security is supposed to be oversold and ready for an upward correction. When the security reading is between 70 and 100, the security is supposed to be heavily bought and is ready for a downward correction.

The first vertical line marked from left shows a level where RSI is below 30, in fact RSI is 26.8. Hence RSI suggests that the stock is oversold. In this particular example, the RSI value of 26.8, also coincides with a bullish engulfing pattern. This gives the trader a double confirmation to go long! Needless to say, both volumes and S&R should also confirm to this.

The second vertical line, points to a level where the RSI turns 81, a value which is considered overbought. Hence, if not for looking at shorting opportunities, the trader should be careful in his decision to buy the stock. Again, if you notice the candles, they form a bearish engulfing pattern. So a bearish engulfing pattern, backed by an RSI of 81 is a sign to short the stock. What follows this is a quick and a short correction in the stock.

The example that I have shown here is quite nice, meaning both the candlestick pattern and RSI perfectly align to confirm the occurrence of the same event. This may not always be true. This leads us to another interesting way to interpret RSI. Imagine the following two scenarios:

Scenario 1) A stock which is in a continuous uptrend (remember the uptrend can last from few days to few years) the RSI will remain stuck in the overbought region for a long time, and this is because the RSI is upper bound to 100. It cannot go beyond 100. Invariably the trader would be looking at shorting opportunities but the stock on the other hand will be in a different orbit. Example – Eicher motors Limited, the stock has generate a return of close to 100% year on year.

Scenario 2) A stock which is in a continuous downtrend the RSI will be stuck in the oversold region since the RSI is lower bound to 0. It cannot go beyond 0. In this case as well the trader will be looking at buying opportunities but the stock will be going down lower. Example – Suzlon Energy, the stock has generated a return of negative 34% year on year.

This leads us to interpret RSI in many different ways besides the classical interpretation (which we discussed earlier)

1. If the RSI is fixed in an overbought region for a prolonged period, look for buying opportunities instead of shorting. The RSI stays in the overbought region for a prolonged period because of an excess positive momentum
2. If the RSI is fixed in an oversold region for a prolonged period, look for selling opportunities rather than buying. RSI stays in the oversold region for a prolonged period because of an excess negative momentum
3. If the RSI value starts moving away from the oversold value after a prolonged period, look for buying opportunities. For example, the RSI moves above 30 after a long time may mean that the stock may have bottomed out, hence a case of going long.
4. If the RSI value starts moving away from the overbought value after a prolonged period, look for selling opportunities. For example, RSI moving below 70 after a long time. This means the stock may have topped out, hence a case for shorting

One last note

None of the parameters used while analyzing RSI should be treated with rigidity. For example, J.Welles Wilder opted to use a look back period of 14 days simply because that was the value which gave the best results considering the market conditions in 1978 (which is when RSI was introduced to the world). You may choose to use 5,10,20, or even 100 days look back period if you wish too. In fact this is how you develop your edge as a trader. You need to analyze what works for you and adopt the same. Please note, fewer the days you use to calculate the RSI, the more volatile the indicator would be.

Also, J.Welles Wilder decided to use 0-30 level to indicate oversold regions and 70-100 level to indicate overbought region. Again this is not set in stone, you can arrive at you own combination.

I personally prefer to use 0-20 level and 80-100 level to identify oversold and overbought regions respectively. I use this along with the classical 14 day look back period.

Of course, I urge you to explore parameters that work for you. In fact this is how you would eventually develop as a successful trader.

Finally, do remember RSI is not used often as a standalone indicator by  traders, it is used along with other candlestick patterns and indicators to study the market.

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Key takeaways :

1. Indicators are independent trading systems developed, and introduced by successful traders
2. Indicators are leading or lagging. Leading indicators signals the possible occurrence of an event. Lagging indicators on the other hand confirms an ongoing trend
3. RSI is a momentum oscillator which oscillates between 0 and 100 level
4. A value between 0 and 30 is considered oversold, hence the trader should look at buying opportunities
5. A value between 70 and 100 is considered overbought, hence the trader should look at selling opportunities
6. If the RSI value is fixed in a region for a prolonged period, it indicates excess momentum and hence instead of taking a reversed position, the trader can consider initiating a trade in the same direction.

Tips to trade with RSI.

1. A general rule of buying when RSI moves from below 30 to above with combination of another indicator like rise in volume or Moving average crossover or any other indicator of your choice.

2. A general rule of selling when RSI moves from above 70 to below with combination of another indicator like rise in volume or Moving average crossover any other indicator of your choice.

3. When RSI trend is falling and price trend is rising and RSI is in overbought state then a reliable sell signal is generated.

4. When RSI trend is rising and price trend is falling and RSI is in oversold state then a reliable buy signal is generated.

5. For those who use end of the day data may profit from RSI in 1-7 days or more days.

6. Less risky traders should wait for RSI move above 30 from below 30 to take a position.
    Aggressive traders sometimes even take 35/65 as an oversold and overbought range.

7. RSI values can be altered for different types of stocks. For extremely stable stocks or small price ranging stocks a value of 35 may be a good entry point and for highly volatile stock a value of 25 may even be considered as high risk.

8. Trend reversal at 70 /30 is considered to be 75% accurate.

9. Trend reversal for divergence is considered to be about 80% accurate.

Divergence loses its significance in a sideways market.

Warning:-

a. Buying stock just based on its value below 30 may lead to losses. In stock downtrend, RSI may stay below 30 for a long time with continuous fall in price.

b. Similar to aforementioned point selling just based on RSI above 70 may reduce your profit.

c. In extremely strong trend, RSI can yield wrong results.

d. In some cases, RSI and price divergence can last for a longer time before trend reversal. Traders need to be patient with it.

e. Not all stock movement will generate RSI buy/sell signals

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