When it comes to analyzing the stock market, the Relative Strength Index, or RSI, is a tool that traders often reach for. Developed by J. Welles Wilder in 1978, the RSI is a momentum indicator and oscillator, crucial for measuring the speed and change of price movements. Momentum indicators, like the RSI, help traders understand how strong a trend is, while oscillators provide signals about potential reversals by fluctuating between two extremes. Even after more than four decades since its development, the RSI remains one of the most popular and trusted indicators among traders globally. Its enduring popularity is due to its simplicity, effectiveness, and the valuable insights it provides into market conditions.
So, how exactly is the RSI calculated? At its core is the formula
RSI = 100 - (100 / (1 + RS))
where RS stands for Relative Strength, calculated by dividing the average gain of up periods by the average loss of down periods over a set time frame.
While this formula might seem complex, I won't delve into the detailed calculations here, as that’s beyond the scope of this article. Instead, I want to focus on the practical aspects of the RSI, where its real power lies. Rest assured, I’ll cover the calculation part in a future post for those interested in the math behind the magic.
On a stock chart, the RSI is typically displayed as a line beneath the price chart, moving up and down between the extremes of 0 and 100. When interpreting RSI, certain key levels, like 30 and 70, are particularly significant. Let's explore these levels and understand why they matter. See the picture below. You can see RSI plotted below the price chart oscillating between 0 and 100.
1. Levels 30 and 70- These are perhaps the most commonly referenced RSI levels. When the RSI drops below 30, the stock is considered "oversold," suggesting it may be undervalued. Conversely, when the RSI rises above 70, the stock is said to be "overbought," indicating it may be overvalued.
However, it's important to note that an oversold or overbought RSI doesn't automatically signal a buy or sell opportunity. Stocks can remain in these zones for extended periods, especially during strong trends.
Some traders prefer to buy when the RSI, after being in the oversold region, climbs back above 30 (or sell when it falls below 70). This strategy can be risky if the RSI is used alone. However, when combined with other indicators, like the Bollinger Bands, it can provide stronger signals.
For example, if a stock's price touches the lower Bollinger Band and the RSI moves above 30, it could be a more reliable buy signal. Similarly, a price hitting the upper Bollinger Band with the RSI moving below 70 might signal a selling opportunity. See the image below.
2. Level 50: The midpoint between 30 and 70, RSI level 50, can be a valuable tool for confirming trend direction. In an uptrend, the RSI typically stays above 50 and frequently approaching the 70 level. Conversely, in a downtrend, the RSI mostly remains below 50, often nearing 30. This level can also be used to generate trading signals when combined with the 200-period Exponential Moving Average (EMA).
For instance, when the 200 EMA slopes upward (indicating an uptrend) and the RSI crosses above 50, it may signal a buying opportunity. On the flip side, if the 200 EMA is slanting downward (suggesting a downtrend) and the RSI crosses below 50, it might be a signal to sell.
3. Levels 60 and 40: These lesser-known levels are also important. In an uptrend, the price tends to accelerate once the RSI crosses above 60, while in a downtrend, the price can drop quickly once the RSI dips below 40. Some traders use these levels as additional buy or sell signals, though caution is advised, and it's recommended to use other indicators in conjunction.
While the Relative Strength Index (RSI) is commonly known for identifying overbought and oversold conditions, as well as quantifying momentum, it also has the powerful ability to predict potential trend reversals through RSI price divergences. These divergences occur when the movement of the RSI is in opposition with the price action, signaling a possible shift in the prevailing trend.
A divergence takes place when the price moves in one direction, but the RSI does not follow suit. For example, if the price makes a new low but the RSI fails to make a new low or makes higher low, this is considered a divergence. This conflict between price and RSI indicates that the underlying strength of the trend may be weakening, putting potential reversal on horizon.
Divergences can be categorized into two types: bullish and bearish divergences. A bullish divergence typically occurs near the oversold region when the price makes a new low, but the RSI makes a higher low. This situation suggests that the downward momentum is losing strength and could indicate a potential reversal to the upside or at least a pullback. This has been shown in the image below.
As you can see in image above the price makes a lower low as shown by blue trendline but RSI doesn't follow the suit and makes a higher high instead. Notice that the price goes for a northward journey after the divergence.
Conversely, a bearish divergence happens when the price makes a new high, but the RSI fails to reach a new high, often near the overbought region. This signals that the upward momentum may be fading, and a downside reversal or pullback could be imminent. See the picture below which shows bearish divergence.
You can notice in the chart above that price makes a higher high but RSI makes a lower high as shown by blue trend lines suggesting a bearish divergence. Also see that price begins to fall after the RSI divergence.
You can appreciate now that RSI is a powerful tool for spotting trading oppurtunities However, traders should exercise caution and not enter a trade solely based on spotting a divergence, as divergences can sometimes fail.
To improve the reliability of trading divergences, it is better to wait until the price has broken out or broken down through a significant resistance or support level. Additionally, other indicators can be used alongside divergences to validate the signal. Indicators such as Bollinger Band, MACD (Moving Average Convergence Divergence), or ADX can be helpful in confirming the potential reversal signaled by the divergence.
Look at the chart below that illustrates how RSI and Bollinger band combined gives powerful signal.
In conclusion, the RSI is a powerful tool that offers valuable insights into market conditions and potential price reversals. By understanding and using key RSI levels—30, 50, 70, 60, and 40— and by spotting divergences you can better navigate the complexities of the stock trading.
Remember, while RSI is important, it should not be used in isolation. Combining RSI with other indicators, like Bollinger Bands or the 200-period EMA, can provide more reliable trading signals. Through this article, I hope you've gained a deeper understanding of why RSI remains a favorite among traders and how you can apply it in your own trading strategy.
Further Reading-
-Relative strength strategies for investing by M Faber
- Relative strength strategies in China's stock market: 1994–2000 by C Wang
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