Developed by a technical analyst, J. Welles Wilder, RSI or Relative Strength Index is one of the most popular indicators used in the trading sector today. The Relative Strength Index is basically a measure of a stock’s performance against its own self by comparing the strengths of its up days versus its own low ones.
RSI mainly indicates the overbought and oversold conditions of a particular stock in the market. The optimized mathematical formula for RSI is generally given as
RSI = 100 – 100 / (1+RS*) * RS = Average gains / Average losses
Thus RSI number will always lie between 0-100.
Readings below 30 indicate oversold market conditions while that above 70 indicate overbought conditions. However, some traders go beyond these safe limits and prefer the extreme limits of 80 and 20 respectively.
However, RSI does not limit itself to indicating the overbought and oversold conditions.It also helps traders with special apprehensions like:
- Application of the Trend Lines: Just like the closing chart, RSI gives an advanced signal that price is going to break the trend line within a day or two but in a more accurate way.RSI trend lines would be broken at least 3-4 days before the actual stock to break the trend line and thereby help the trader to predict the market conditions.
- Advance breakout and breakdown: Here too like the OBV indicator, RSI gives an early signal which indicates that price will also follow the indicator in coming to few sessions.RSI indicator breaches the previous top of the particular stock while the current price hasn’t breached the previous top yet, indicating the future possibilities. Similar is the case with early breakdowns. It thereby helps traders achieve maximum profit and incur a minimum loss.
- Pattern breakout: Since RSI calculations are done considering the underlying relative strength of a stock over a specified period of time it can smoothly predict and indicate the possible future breakouts that will occur at least 2-3 days in advance. Thus a safety pattern is got from well ahead.
- Role of 50: although the usual range is from 30 to 70, the mid 50 line acts as a very important line to indicate the price direction in case of the RSI indicator. During the bullish period, the prices generally stay above the mid 50 line while it faces resistance from the same 50 line during the bearish phase of the market. Thus this mid line plays a big role when investing in long-term trading.
- Failure swing: when the RSI drops below 30, a swing curve is formed indicating the low conditions. Thus it helps predict the oversold condition of the market.
Thus we see that RSI is an extremely versatile indicator with many a purpose. However it is not an absolute indicator of the market. Its biggest drawback lies in the fact that sudden or sharp price rise or movements can make the index go up and down repeatedly and thereby lead to false or erroneous signals. This at times could be misleading for the trader.
It takes quite a lot of experience to understand the RSI index and trade safe in the market.