Relative Strength Index or RSI as it is popularly known is a quite useful indicator for technical analysts and traders. This is the most simple and widely used indicator for technical analysis of stocks.
Its usefulness lies in its ability to generate buy and sell signals for a security, especially for swing trading.
Relative strength index is a leading indicator which means it gives signal regarding movement of a security before that security has actually moved in that direction .
This property of RSI enables a trader to grab bigger move of the security and thus maximizing the profit potential.
RSI is actually momentum oscillator, the value for which keeps oscillating between two extremes of a range.
This range comprises of 80 on higher side and 20 on lower side. The RSI settings are 14 periods in most of the technical analysis software but you can adjust it to any value according to your trading time horizon.
RSI indicates the strength or weakness in a security on a chart and it is formed of closing prices of that security.
There is a formula for RSI calculation but with modern charting software of today’s, you don’t need to calculate it.
With one click, it draws the historical and current data on the chart and you get the RSI graph.
Relative Strength Index Indicator
The upper range of 80 for RSI indicator implies that the security is in overbought territory and may correct in near term. But it is not so necessarily as the securities have the tendency to stay in overbought territories for longer periods of time.
This is more common when the markets are in strong bullish uptrend.
Similarly, the lower range of 20 indicates that a particular security is in oversold territory and may bounce back. Again, not necessarily as the securities have the tendency to stay in oversold situations for longer periods without giving any significant bounce. This is common while markets are in strong bear grip and in strong down trend.
Taking all the above points into consideration, we may assume for trading purpose that the security may take a turn after hitting these extreme ranges.
Some traders or analysts can consider range of 70 and 30 instead of 80 and 20 for trading purposes although the later range is considered safer.
If a security has fallen and the RSI has pierced the lower range level of 20, you can look to buy it in anticipation of bounce back.
Buy signal is generated when the RSI indicator has risen above the 20 level after going below it. Then you wait for price appreciation and look to exit when the security reaches 70 or 80 range.
For short selling, a sell signal is generated when RSI indicator turns down below 80 range level after piercing above this range. You should close you short position as RSI moves towards 30 or 20 RSI level.
There are bullish and bearish RSI divergences when the security and RSI for it behave differently.
For instance, in case of bullish divergence, the underlying security keeps on making lower lows while the RSI makes higher lows.
It implies that the selling pressure in the security is about to wane and it may move higher in near future. This is a strong signal to go long in that security.
For bearish RSI divergence, the security makes higher highs and the RSI makes lower highs. This suggests that buyers in the markets are getting weaker and the security may correct in near futures. This makes a strong sell signal for short sellers and longs who have entered the security at lower price levels.
Although RSI indicator is commonly used by the traders and analysts and it is quite reliable too but being a leading indicator, it has its own drawbacks too.
The signals generated may go wrong also as the security has not yet moved in our desired direction.
It is always in a trader’s interest to use relative strength index indicator in combination with other indicators like Stochcastic and Momentum etc to bring more accuracy in prediction.