The Relative
Strength Index or RSI, was developed by J. Wells Wilder in 1978. Since then
this tool is being used by many chart analyst to ascertain the momentum of the
stocks. The
main purpose of this index to observe the market's strength or weakness
The RSI is plotted between 0 and
100. Within this range there are two levels to look for. One is the 20 level
and the other is 80 levels. 30 and 70 also can be used depending on the market
condition or stock. The upper level (20/30) normally represents the oversold
condition. The lower level (70/80) represents the overbought condition.
Take a
closer look at the above chart. In this Syndicate Bank chart we can observe the
RSI oscillator action very clearly. When the stock is in uptrend the RSI
indicates that the stock is in overbought zone. Similarly when the stock climbs
down the RSI indicates that the stock is oversold.
The
traders usually sell their stocks or go short when they see the stock price in
the overbought zone. When the stock enters the oversold zone the traders see it
as an opportunity for buying or accumulating the stock.
As can be
seen, when the RSI dips below the 30 a buy signal is formed. When the RSI rises
above the 70 a sell signal is formed.
In the
above chart we see a different picture. The RSI keeps warning that the stock is
in the danger zone and traders might press the sell button. But it does not
happen. The stock continues its journey upwards.
The above
chart describes another view. The RSI keeps on pointing at oversold areas, but
the stock takes a downwards journey.
In both the charts presented above we observe one thing in common. The
strength of the trend is high. In the IDEA chart the uptrend is very strong. In
the JINDALSWHL the downtrend is extremely high. If the traders adopt the
approach of selling at over bought levels and buying at oversold levels in a
trending market they can end up minus their money. Since they will be acting against
the trend, which is a recipe for a disaster.
Then how
the RSI can help a trader?
The RSI
works well in a sideways market. The strategy of buying at oversold levels and
selling at over bought level can work well in a sideways market only.
Divergences can
be regarded as good trading signal. A positive divergence can be observed when
the RSI makes a higher bottom despite the downtrend of the share price.
Similarly, a negative divergence can be seen when the RSI starts falling and share
price is on the uptrend. The
divergence pattern is rare to come across.
Another method to trade using the
RSI, is to trade centerline crossovers. When the RSI rises above the 50, a
signal is generated to buy. When the RSI comes below the 50 the signal will be a
sell. This too can give a safe entry points to trade the market
RSI
Formula =
100 - (100/1 + RS)
The RSI formula looks simple but rather puzzling. To understand
this formula let us assume the RSI
period is 14 days. During this period, if the stock price rises for all
14 days without any break, then the RSI value would be 100. If the price of the
stock keeps on descending on all 14 days the value of the RSI would be 0. If the stock prices rose only for 10 days and
falls for the remaining period, only the 10days gains will be added up and divided
by 14 which in turns gives the average gains for 10days. The loss making 4 days
gains will also be added up and divided by14 to arrive at average losses. The ratio
between average gain and average loss is known as Relative Strength RS. I hope
this explains well the formula of RSI.
The RSI cannot be used as a standalone buy sell signal
generator. This could be used along with other indicators, which is the best
way to use this oscillator. Based upon the market conditions and individual
stocks the use of RSI can certainly be a valuable tool.
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