What is the RSI indicator? – Relative Strength Index and its importance for a trader in the stock market

RSI stands for Relative Strength Index and is a popular and essential indicator used by the trader while trading in the stock market. It is used by both long-term and short-term traders to complete their trades. RSI indicator indicates the strength of the momentum of the trend or price of the stock. It is used with one or more other technical Indicators like MACD to assess the market behavior. So being a trader, we must know about this vital indicator to enhance accuracy in the trades.

what is a rsi indicator?

What is RSI Indicator

RSI indicator is an important technical analysis tool used to indicate the speed and change in the price of the stocks in the market. It is an oscillator that oscillates between the range of 0 – 100. This oscillator cannot go above 100 and below 0 in its pattern. It was developed and designed by an American Mechanical Engineer named J Welles Wilder in the year 1978. He also invented other indicators like ADX, ATR, and Parabolic SAR which are used in the technical analysis of the stocks in the stock market for forecasting their price movement.

It calculates the momentum based on the rise and fall of the stock price during the day and it shows its value over a period of timeframe. RSI indicator works with the same accuracy in every market like stock, commodity, Forex, and Future & Options. It is a leading indicator means it indicates the future possible trend based on the previous data used by it in its calculations. Hence it can be used to spot the general trend of the stock price movements by the traders.

Basics of RSI

It is a momentum oscillator used to indicate the strength and thereby help a trader forecast the possible future stock direction. Since it is an oscillator, it will oscillate between a range, and that range is from 0-100. The value of RSI always remains within this range. It has some important levels in its pattern at the values of 30, 50, and 70 which are most important for a trader to understand.

rsi indicator usage

When the value of the indicator goes beyond 70, it is generally believed that the market is now in an overbought condition. That means market trend reversal can happen in the near future as Sellers are gaining control of the market. But it is just a probability and not confirmation because sometimes an RSI level above 80 indicates a strong Bullish influence. When the value of the indicator goes below 30, it is generally believed that the market is now in an oversold condition. That means market trend reversal can happen in the near future as Buyers are now in full control of the stock market.

RSI Value  Market Trend
50-100 Bullish zone
50-0 Bearish zone
Above 70 Overbought
Above 80 Extremely Overbought
Below 30 Oversold
Below 20 Extremely Oversold

How to calculate RSI

The calculation is based on the rise and fall in the price during the day and the average loss and gain are calculated for a time period. This time period is fully customizable and we can specify the number of days to be used in the calculation. However, the default setting uses a time period of 14 days in its calculation which is considered best by the majority of the traders. There is one formula that is used to calculate the relative strength of the stock price over a period of time.

RSI = 100 – 100 / (1 + RS)

Where RS  =  Average Gain over a specified period/ Average loss over the same period

For example, if we take a period of 14 days, and out of those 14 days, we have a gain for 5 days and a loss for 9 days. Then the average gain will be 5/14 while the average loss will be 9/14.

But you don’t need to worry because this calculation is done by the software present in your charting application and it will give you the final value of RSI.

The default setting of 14 days time period can be changed but it will affect the sensitivity of the indicator. As the number of days is reduced sensitivity of the indicator will increase. That means an RSI of 14 days will be more sensitive than an RSI of 20 days.

How RSI Indicator works

RSI Indicator oscillates between the value of 0 to 100 and is considered overbought when its value tops 70, while the stock is considered oversold if the RSI value falls below 30. But these values can be changed by the trader based on his trading strategy. It is possible that sometimes the market remains in a strong trend and in that case RSI can remain in an overbought or oversold zone regularly for a long time. In such cases, a trader can change the setting from 70, 30 to 80 & 20 so as to predict the correct trend in the market.

When the market is in an uptrend or Bull phase, RSI tends to remain in the zone between 50 to 90 where the range of 50-60 acts as support. While in the Bearish phase, RSI tends to remain in the zone of 50 to 10 where the range of 40-50 acts as resistance.

•          RSI also often forms chart patterns that may not show on the underlying price chart, such as double tops and bottoms and trend lines. Also, look for support or resistance on the RSI.

•          If underlying prices make a new high or low that isn’t confirmed by the RSI, this divergence can signal a price reversal

rsi and macd indicator

How to trade with RSI

Before trading with any of the indicators, we must not forget to follow the golden rules of trading, and that is to apply the stop loss in every trade. And Profit booking in each trade must be according to the 2% principle of the Risk Reward Ratio.

Buying with RSI

If you want to enter the market for trade, you must use the proper timeframe based on your investment strategy. If you are trading with the timeframe of the Daily chart, we must also see the RSI levels in the weekly and monthly charts for greater accuracy.

RSI levels between 50-70 in weekly and monthly charts indicate a strong bullish phase and you should enter the market. We must go for buy trade only when the market is in the Bullish phase and sell when in the bearish phase because we should not take trade against the trend.

Now we can trade with the Daily timeframe provided weekly and monthly RSI is above 50. You must look for candlestick-making support at the level of 50 and enter into the trade at the next candle of this candle. Your stop loss for this trade should be at the low of the. You can hold your trade till the time indicator value drops below 70 or you observe any negative breakout.

Selling with RSI

If you are taking trades in the Bearish trend then you should act in the opposite of the process defined for the Bullish trend. The market should be below 50 in both weekly and monthly time frames and the price must be making resistance at the level of 50. Take the trade on the next candle which makes resistance and use the stop loss at the High of that swing. You can hold your trade till the indicator value remains below 30 or you observe any positive breakout.

Final Words

RSI is a great tool in the hands of a trader to improve his trading accuracy, but you should not blindly follow this. Because sometimes, the false signals generated by this tool can lead you to losses. To improve accuracy in your trade, you must use it with the other technical Indicators like Bollinger Band or MACD. It will help you precisely manage your trade and thereby minimizing your losses.

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