Tutorial on Relative Strength Index (RSI)

Chartists are constantly looking for ways to help them see the market's price trends in advance.

It is not a new trend to search for technical trading methods. Since long ago, traders have been trying to find ways to accurately predict fluctuations in price to make their investment decisions. Continuous efforts are made to determine when market sentiment changes using Bollinger Bands, candlestick charts, and Bollinger Bands. One such tool is the momentum oscillator, which helps traders to understand the strength and direction of a price trend. These tools help to measure price change and determine the strength or inflexion of a price trend. RSI, unlike moving average, is a leading indicator. This article will focus on RSI, or relative Strength Index. It is a popular momentum oscillator that can be used to study buy and sell signals in price charts.

The Relative Strength Index is a momentum indicator that measures the extent of price changes. This is one unit that traders use to determine if a stock has gone too far.

RSI predicts reversals and calculates the strength a stock trend.

What's a momentum oscillator?

RSI stands for momentum oscillator indicator. But what exactly is it? J. Welles Wilder first introduced the concept of momentum oscillator in his book New Concepts in Trading Systems. Understanding RSI is not enough. One must also know how the momentum oscillator works. These indexes can be used together to predict market sentiment shifts.

Momentum is used to predict the speed and frequency of price movements in a market. John J. Murphy outlined it in his book and gave its formula.

Market momentum can be measured by continuously taking price variations for a set time period. Simply subtract the closing price 10 business days ago from the current closing price to create a 10-day momentum line. This is the formula for momentum:

M=V-Vx

Where: V =The most recent price

Vx = The closing price and days ago

This simple formula can be used to determine the strength or weakness of a stock. This is especially useful when the market is rising, as bullish spells tend to last longer than bearish.

Background RSI

J. Welles Wilder introduced the relative price index (RSI) in the same book. This indicator uses a range from 0 to 100 to indicate if a stock has been overvalued. RSI is a measure of how much a stock price has moved above 70 percent. This indicates that it is overbought. The same applies to stocks that are below 30 percent RSI. It is considered oversold.

RSI can be used to indicate whether a market is bullish/bearish. It also helps to identify general trends.

Formula for calculating RSI

The following formula is used to calculate RSI:

RSI = 100-( 100 / 1 +RS)

RS = Average gain/Average loss

How do you calculate the average gain or loss

This RSI formula can be calculated for a period of 14 day, as suggested by Weddle's book.

First Average Gain = Total gains in 14 days/ 14

First average loss = loss in excess of 14 days/14

2 nd Average, and the subsequent average are calculated as follows:

• Average Gain = [(previous average gain) x 13 + current gain] / 14.
• Average Loss = [(previous Average Loss) x 13 + current Loss] / 14

Smoothening is the practice of combining current and past values. This helps RSI to be more precise in technical analysis.

Wilder's formula was an improvement to calculating RS. It became an oscillator that swings from '0' to '100 to indicate whether the market is volatile or not. RSI is zero when the Average Gain equals zero. For example, RSI zero on a 14-day period indicates that the price movement was lower than average and there is no gain.

RSI 100 is a measure of price movement in the higher range for 14 days. There is no loss.

The default lookback period of RSI is 14. To increase or decrease sensitivity, traders can adjust the value.

The RSI value will differ slightly due to a smoothening effect. Smoothening effects will be greater for RSI that is calculated over a period of 250 than those calculated over 30 periods.

Let's take RSI as an example.

Let's assume that there was a gain in seven days compared to 14 days. The average loss for the seven remaining days was -0.8%. The RSI is calculated by:

Use the General Rule of Thumb to Study RSI Indicator

RSI is a market indicator that indicates overbought conditions and can be used to help cover profits. It can also identify oversold stocks to help with a possible reversal. RSI breaks price charts into several areas between zero and 100, and traders examine the price line between these extremes. The most popular region is between thirty and seventy, which indicates oversold or overbought conditions, respectively.

It can also be used to study general uptrends and downtrends, respectively over 50 and below 50 lines.

Divergence should be what you are looking for when studying RSI. Divergence in RSI indicates that the point of Inflexion is reached, at which the price line could change direction.

Wilder classified divergence into positive and negative. Wilder stated that directional movements don't always confirm a price. Therefore, it is important to recognize deviations for potential changes in trend. Divergence refers to a situation where the price line or RSI moves in the opposite direction.

Positive divergence refers to a situation in which RSI makes higher highs and lower lows but the price line registers a lower top and bottom.

Negative divergence occurs when RSI registers lower highs and lower lows against higher highs and lower lows of the price line. Chartists search for the point where divergence is evident in a price graph to plan entry into the market.

How do you interpret an RSI indicator

A stock's value can reach 70 overbought limits during a bullish market. The RSI value can then be adjusted to 80 to indicate strong trends if it occurs.

RSI is more complex than a price-line chart. It can show details like double tops and double bottoms that a price line chart cannot. It also provides information about the stock's support and resistance levels.

- The support zone between 40-50 is helpful in bullish markets where RSI is between 40 and 90. The same applies to a bear market that is between 10-60 ranges. The region between 50-60 acts as resistance.

Divergence is when a price line shows a new low or high that is not confirmed by RSI. This indicator is crucial and shows a price trend reversal.

Divergence also includes top swing and bottom swing failures. A Top Swing Failure occurs when RSI makes a lower high, which is then followed up by a downward move below a previous lowest. A Bottom Swing Failure is also possible when RSI marks a lower low which is followed by an upward movement above a previous peak.

Limitation on RSI

As with all indicators, RSI's results are most reliable when they conform to long-term trends. Real reversal signals are rare so it is important to filter out false signals. A false positive RSI value could indicate a stock price that has experienced an overbought signal and then a sharp fall. False negatives can also be triggered when stock prices accelerate suddenly after a bearish crossover.

Secondly, RSI indicators can remain in an overbought/oversold range for a prolonged time while the stock is showing the opposite movement. It is therefore more useful when the price fluctuates between bearish and bullish ranges.

Conclusion

RSI can be used to show traders when the trend is changing. It is an effective price action tool that can be used to predict trend reversal, provided we are aware of its limitations.