With the engagement of more and more common men in the trade market, the use of indicators is gaining popularity day by day. Various indicators like the MACD, RSI, moving average, Bollinger Bands etc are gaining popularity. Just as indicators have a lot of positive impacts, they carry with them a lot of confusion as well.
The advent of so many indicators, and trade experts guiding through almost all of them, it has become really troublesome for the common men traders to choose the right indicator for their trading style.
Some are long-term investors while some are short terms. Some, on the other hand, practice day trade. Depending on the style of trade, it is important to pin down the appropriate indicator.
RSI or Relative Strength Index is a simple yet effective indicator used for trading in the intra-day market. RSI is a majorly used to measure the velocity and the change of directional price movements. This change helps to generate a clear measure of the strength of a trend.
It was first developed by a technical analyst named J. Welles Wilder in June of 1978 and have remained popular ever since.
While following RSI indicator one thing must always be kept in mind that RSI measures the stock’s internal strength only. It has nothing to do with the relative strength of the particular stock, compared to other stocks, market indices, sectoral indices, etc.
Using the relative strength index
RSI is used to identify overbought and oversold conditions of a particular stock in the market.
RSI indicator calculates and produces some numerical values to the traders, depending on which the trader decides his or her next move with the stock.
This value lies in the range of 0 to 100.
For computing the RSI benchmarks. the index is firstly calculated considering a specific time period and the average gains and losses are identified for the chosen period. 14-days is by default the period chosen, however, it can be 20,10 days etc
Next, the days when the stock had gained are separated from the days when it had a fall. These days are separately calculated.
The absolute gains on each of these high days are added up and divided by the chosen no. of days (generally 14) and the average gain is calculated. Similarly, the absolute losses on each of the down days are added up and divided by the chosen no. of days (generally 14) and the average loss is calculated.
The ratio between these values (average gains / average losses) is known as relative strength (RS).
The optimised mathematical formula for RSI is generally given as
RSI = 100 – 100 / (1+RS*) * RS = Average gains / Average losses
After knowing such calculations and mathematical formulae the most common question that will pop up in traders mind is then “What is a good RSI number?”
Well, before fixing it one must know that an RSI value of seventy (70) indicates overbought and thirty (30) indicates oversold. Thereby a good RSI number is the one which lies in between. Basically an average of the two.
Some traders go beyond these safe limits and prefer the extreme limits of 80 and 20 respectively.
Here lies another twist. “ Can the trade term be decided from the RSI value?”
Well again, in general, it is considered safe to consider a short position in case the asset enters the overbought region. Similarly, a long position is to be considered if oversold positions are seen
Another significance of RSI is to determine the divergence of the market. A divergence is a tool that is used to spot potential market reversals by comparing indicator and market direction.
Changes in RSI are based on the prices it follows. Divergence occurs when price splits from the indicator and they begin heading in two different directions.
This condition is very crucial as the stock value can change drastically depending on such divergences. Thus
However to conclude, traders should never solely rely on these RSI numbers as they are not absolute. Several other factors impact the stock and price movements that RSI does not consider in its calculations.
The trader must keep those in mind as well while making a decision.
RSI should, therefore, be used in conjunction with other indicators and fundamentals.
It takes quite a lot of experience to understand the RSI index and trade safe in the market.
We at ProRSI have a team of experienced traders to help you with all your trading needs.