The stock market or share market is where we can buy and sell shares of companies. It includes a vast and complex network of trading activities protected by law so that we can’t commit fraud or practise unjust trading. In modern economics, the stock market plays a crucial role in developing our economy by enabling the movement of money between companies and investors.
Picking the right stock isn’t easy; it takes a lot of effort. To pick the right stock, we need to do a lot of research and review various technical analysis charts. As investors, we must gain confidence in the company before making a sound investment decision.
Technical analysis is a fundamental part of investing. It is the process in which we use historical market data to predict price movements in the future. Technical analysts predict future market behaviour by using performance data. Insights from behavioural economics, quantitative analysis, and market psychology also help make investment decisions. Once we feel that the company’s future performance will yield profits and, in turn, increase the stock price, thus making us a profit in the process.
RSI, or Relative Strength Index, is a vital share market technical analysis tool. Let us understand RSI and how it helps us make our decisions.
What is RSI?
J. Welles Wilder developed the Relative Strength Index, a momentum oscillator that measures the speed and change of price movements. The RSI oscillates between 0 and 100. It helps us identify overbought or oversold conditions, divergences, and potential trend reversals. Even though it is not a foolproof indicator, it becomes a valuable tool if used correctly.
In a Relative Strength Index, if we get readings above 70, an overbought condition suggests a downward price reversal. In contrast, getting readings below 30 means a price reversal upwards, as there is an oversold condition. Don’t think this is a rule of the stock market written in stone. It is instead a probability, as it also depends on other uncertain market factors.
Chart patterns:
RSI often forms chart-like patterns that may not be visible on an underlying price chart, such as double tops and trend lines. During a bull market, the RSI usually remains in the range of 4 to 90, with the 40 to 50 zone being a support. Meanwhile, in a bear market, the RSI stays between the 10 to 60 range and the 50 to 60 zone, acting as a resistance.
These ranges vary based on RSI settings, market trends, and stock strength. The divergence signals a price reversal if underlying prices make a new high or low that the RSI does not confirm.
A Top Swing failure occurs when the RSI makes a lower high followed by a downside move below a previous low. A bottom Swing failure occurs when RSI makes a higher low followed by an upside movement above the previous high.
RSI calculation
The Relative Strength Index (RSI) is calculated using the below formula-
RSI = 100 – [100 / {1 + (Average of Upward Price Change / Average of Downward Price Change}]
Here, the average percentage gain or loss is measured over a given or a specific period. In this formula, the losses are treated as positive values. During the look-back period, zero average gain is considered for periods with price losses, whereas periods with price increases have zero average loss. The initial value of RSI is generally calculated using 14 periods.
Interpreting the RSI Signal
The RSI is a precious tool for traders and investors alike as it helps to understand overbought and undersold conditions, divergence, and trend confirmation. Let’s understand each signal in detail-
- Overbought and oversold conditions: They describe the price of a share in relation to its fair value. Overbought and oversold conditions help define future trends and market conditions by providing buy and sell points for shares. If all readings are above 70, it indicates an overbought condition, suggesting a downward price reversal, whereas all readings below 30 suggest a price reversal upwards as there is an oversold condition.
- Divergence: It helps us spot potential price reversals. A divergence is the change in price momentum before a price action. It acts as an early warning signal. There are two types of divergence- bearish and bullish. In a bearish divergence, an overbought RSI reading is followed by a lower high on the RSI. Meanwhile, an oversold condition is followed by a higher low on the RSI graph in bullish divergence. The price must also form a lower low on the second peak simultaneously.
- Trend Confirmation: RSI helps us confirm an existing market trend. If it is above 50 and the price is in an uptrend, it supports the continuation of the uptrend. Just like that, if the RSI is below 50 and the price is in a downtrend, it supports the continuation of the downtrend.
Conclusion
Understanding RSI and adequately applying it enhances technical analysis and helps make more informed decisions before investing. RSI helps predict the price behaviour of shares, validate trends and trend reversals, and point out overbought and oversold securities. RSI also helps investors and traders buy and sell signals for the short term. Data required for RSI can be gained through live stock charts, earnings reports, and reviews from analysts who do stock charts technical analysis and can be found easily online.
Relative Strength Index is a valuable tool, but it has its limitations. The RSI is a lagging indicator as it confirms trends rather than predicting them. It sometimes generates false signals, especially during market volatility and strong trends. Therefore, using RSI with other technical tools and fundamental analysis is critical to achieve a wider and more comprehensive future.
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