Last Updated on September 27, 2023 by BFSLTeam BFSLTeam
Traders in the stock market often perform technical analysis to predict price movements in an asset. A major part of this analysis involves the study of various technical indicators to identify potential trading opportunities. Among the many indicators that are used, the Relative Strength Index is one of the most popular. Here’s everything you need to know about this technical indicator and how you can use it to plan your trades.
Table of Content
What is the Relative Strength Index in the Stock Market?
The Relative Strength Index, also known as RSI, is a technical indicator used to determine the speed and the quantum of change in the price of an asset. Using the indicator, you can quickly ascertain whether an asset is overbought or oversold. Since it is a type of momentum oscillator, it is usually represented as a line graph.
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How to Calculate the Relative Strength Index?
Now that you’re aware of what the Relative Strength Index is, let’s look at the formula used to calculate it. Unlike most other technical indicators, calculating the RSI is slightly more challenging since it involves the use of a two-part formula.
Formula: Part 1
| RSI = 100 – [100 ÷ {1 + (average gain during the period ÷ average loss during the period)}] |
In this formula, the average loss during the period is represented as a positive value. Usually, the Relative Strength Index for any asset is calculated for 14 days.
Formula: Part 2:
| RSI = 100 – [100 ÷ {1 + (previous average gain * 13) + current gain ÷ (previous average loss * 13) + current loss}] |
Once the two-part calculation is done, the results are plotted on a line graph below an asset’s price chart. Fortunately, as a trader, you don’t have to manually calculate the RSI for any asset. Most technical charting tools and trading platforms readily offer this information, which you can simply factor into your trading decisions.
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Understanding the Relative Strength Index
The RSI’s line graph is represented on a scale of 0 to 100. If the Relative Strength Index of an asset moves to 30 or below on the line graph, it signifies an oversold condition. On the other hand, if the indicator moves to 70 or above on the line graph, it signifies an overbought condition.
An asset that stays in an overbought or an oversold territory may undergo a trend reversal shortly. This effectively means that oversold assets may turn bullish and overbought assets may turn bearish. You can use this information to plan your trades accordingly.
However, it is essential to keep in mind that an asset may stay in either the overbought or oversold territories for a long time without showing any signs of a trend reversal. As a trader, you need to account for such behaviour when you place a trade. The best way to circumvent such a situation would be to use other technical indicators to candlestick patterns to confirm the onset of a trend reversal before taking up a position in the asset.
What is a Relative Strength Index Divergence?
A Relative Strength Index divergence is a situation where the RSI of an asset moves in the opposing direction to the said asset’s price. There are two kinds of RSI divergences that you may encounter – a bullish divergence and a bearish divergence.
In a bullish divergence, the RSI of the asset is in the oversold territory (below 30 on the scale) and makes higher lows. At the same time, the asset’s price makes lower lows. If the RSI breaks out of the oversold territory, it indicates a bullish reversal.
In a bearish divergence, the RSI of the asset is in the overbought territory (above 70 on the scale) and makes lower highs. At the same time, the asset’s price makes higher highs. If the RSI breaks down from the overbought territory, it indicates a bearish reversal.
Additional Read: What Is Arbitrage?
Conclusion
The Relative Strength Index is one of the most important tools for a trader. Apart from helping you identify whether an asset is overbought or oversold, the indicator can also validate existing trends and determine potential trend reversal points.
However, as with any technical indicator, the Relative Strength Index may not always generate accurate trading signals. Therefore, it is advisable to read it in conjunction with other indicators and chart patterns. This will provide you with a better context of an asset’s price movements.
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