How to use Relative Strength index (RSI) : Tips for new traders

 Investing and trading in the stock market is all about making informed decisions based on price action and certain combinations of indicators. Relative strength index (RSI) is one such indicator that is widely used across the world by both astute and not-so-seasoned traders and investors. 

This article will guide you through the basics of RSI focusing primarily on interpretation and practical uses of the indicator. I would not talk about the calculation of RSI in this article as it is not in the scope of the article also all charting software calculate and construct RSI in the charts and you don't have to plot it on your own.

What is Relative strength index (RSI)

RSI is a momentum oscillator that was developed by J. Welles Wilder Jr. in 1978. RSI indicates the pace with which the price is moving and it oscillates between two levels, 0 and 100. It shows the strength of price movement, that is, how fast or slow the price of a stock is moving. Additionally, it also indicates whether a stock is overbought or  oversold which helps traders take positions in the trade. RSI below 30 indicates the stock is oversold and a reading above 70 indicates the stock is overbought. I will talk about these points in detail later on in the article.

What does RSI look like in a Chart?

As you can see in the picture above an RSI looks like a line graph in a chart and has been plotted below the price chart. Further, this line oscillates between two levels, 0 and 100. Two other levels , 30 and 70, have also been marked in the chart which corresponds to oversold and overbought conditions respectively. Additionally, there is a third level of 50 which has been marked which is the midpoint of these two levels (30 and 70). This level signifies a state of balance between the buyers and sellers.

How is the Relative strength index (RSI) interpreted?

Primarily RSI is used as a gauge to measure momentum and to find oversold and overbought conditions. Further by finding Price- RSI divergences possible reversals can be predicted. This is being discussed below in detail.

1) Overbought (RSI > 70)- RSI moving above 70 suggests that the stock might have been in an uptrend for a longer period of time and that a correction or reversal might be on the horizon. However, this is not a sell or sell short signal as the RSI can remain above 70 levels for extended periods.

2) Oversold (RSI < 30)- RSI moving below 30 is indicative of the stock being in a downtrend for long and a pullback or reversal to the upside is imminent. However, this again should not be inferred as a buy signal as RSI can remain below 30 for longer periods especially if the downtrend is strong.

In the picture above you can see RSI going above 70 and below 30. The levels above 70 have been marked as overbought and levels below 30 have been marked oversold.

3) Momentum (RSI crossing above or below 50)- In an uptrend, RSI crossing above 50 level indicates a strong momentum towards the upside while in a downtrend RSI crossing below 50 can be inferred as strong momentum towards the downside. Some technical analyst, however, opine that RSI crossing above 60 should be viewed as strong momentum on the upside and RSI coming below 40 should be inferred as strong momentum on the downside.

Notice in the image above that the stock is in uptrend and each time RSI crosses above 50 from below the stock price shows accelerated movement towards upside. Shown in the image with red dots.

Practical uses of Relative Strength Index (RSI)/ Trading strategies with RSI

1) To confirm the trend of a stock- RSI can be used as a trend indicator to confirm the trend of a stock. In an uptrend, RSI largely remains above the 50 level and frequently touches the 70 level mark. Similarly in a downtrend, RSI largely remains below the 50 level and frequently touches the 30 level mark.

Let's understand this with the help of charts.

Notice in the image shown alongside that RSI remains above the 50 level and frequently touches the 70 level. Also, you can notice that the price is making higher highs and higher lows signifying that the stock is in uptrend.

In the image shown alongside you can notice that RSI remains below 50 for the most part and frequently touches the 30 level mark when stock is in a downtrend and goes above 50 once stock price picks up.

2) To trade Divergences- Divergences occur when the price moves in one direction and RSI moves in another direction. For example, if a stock makes a new low but RSI fails to make a new low then we say there is a bullish divergence between RSI and price. Similarly, if the price makes a new high and RSI fails to make a new high there is bearish divergence between price and RSI.

Divergences signify that the existing trend is losing momentum and a reversal or pullback might be on the horizon. Let's understand this concept with a chart.

You can see in the above chart that the stock was in a downtrend and the price made a lower low as shown through the blue line in the upper pane but RSI made a higher low. Subsequently, the stock reversed the trend direction and went up. This is a bullish divergence.

3) To validate Buy/Sell signals given by other indicators-  RSI can also be used to differentiate between false and genuine buy/sell signals given by other indicators.

For example, a price crossing above a moving average is considered a buy signal but if you enter a trade based solely on this signal there would be higher chances of losses. But if we include RSI in the analysis chances of a successful trade are increased. Price crossing a moving average and simultaneously RSI above 50 would be a better signal for trade with lesser chances of whipsaws.

You can also use this concept with other indicators that give buy/sell signals as well like MACD crossover, Parabolic SAR, golden cross, and death cross to name a few.