Relative strength index (RSI) is one of the momentum indicators which uses for technical analysis and is computed on the basis of the direction and speed of a stock’s price movement. The main reason for using RSI is to identify the overbought and oversold conditions in the trading of an asset by measuring the magnitude of recent price changing. It is one of the intraday trading tips which practiced by many traders in order to make decisions on buying and selling stocks. But, before we discuss its usage let’s find out how to calculate the relative strength index (RSI).
How to Calculate the Relative Strength Index (RSI)?
In order to calculate the RSI, one has to identify the average gains and average losses for a specific period of time. For instance, we’re calculating the 14-day RSI. Although one can calculate for any time period – the 14-day is most commonly used.
Anyways, let’s assume the stock went up on nine days buy went down on remaining five days. Now what we’ve to calculate are average gains and average losses.
Absolute Gains = Stock’s closing price on a given day – closing price on the previous day
Absolute Losses = Stock’s closing price on a given day – closing price on the previous day
And the average gains is the addition of absolute gains on each of nine days divided by 14 and the average losses are the addition of absolute losses on each of the five days divided by 14.
The ratio of average gains and average losses:
Average Gains / Average Losses are known as Relative Strength (RS). And the RSI is written as:
RSI = 100 – 100 / (1+RS)
RSI Use in Overbought & Oversold Levels:
Always, remember the RSI value always moves between 0 and 100. If the value is 0 that means that the stock falls on all 14 days but if the value is 100 then the stock moves up on all 14 days. It implies that the RSI can be used to identify the overbought/oversold levels in a counter.
Failure Swings: According to Welles Wilder, the developer of this indicator, the valued above 70 considered as ‘overbought zone’ and below 30 considered as ‘oversold zone’. But the short-term traders face a serious issue when the indicators still continue to move up even after hitting the overbought zone or continue to go down even after hitting the oversold zone. Because of this, the Welles Wilder added a new concept called ‘failure swing’ for the relative strength index (RSI).
There are two types of failure swings:
- Bearish Failure Swing – It occurs when the relative strength index (RSI) enters the overbought zone and comes below 70 again.
- Bullish Failure Swing – It occurs when the RSI enters the oversold zone and comes out.
Both swings can be seen in the Reliance chart.
Divergence: The divergence can be seen in the chart of Bharti Airtel where you will see that divergence here is similar to the divergence rule. A positive divergence occurs when the RSI makes a higher bottom despite lower trending by share price and the negative divergence occurs when the RSI makes a lower bottom despite higher trading by share price.
Trend Direction: The direction of the trend is important for traders and can be benefited a lot of it. The RSI can help in determining the trend of the market. Generally, it moves between 40 and 80 levels. By taking a look at the chart of HCL, one can see that when the RSI approaches 40, it can be used as a buy signal but when it approaches 80, it is the signal of square-off.
Hope, you find this article helpful. Nevertheless, if you have any query or would like to add something then don’t forget to mention in the comment section below.
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