RSI stands for Relative Strength Index which shows the strength of the underlying stock, commodity or indices within its upper band and lower band normally from 0 to 100 (or 0% to 100%). The upper band shows whether the price is overbought or over priced and the lower band indicates the price is oversold or undervalued. Different traders and analysts use different overbought & oversold level, most of them use above level 80 as overbought and below level 20 as oversold which is the default setting in most of the trading software. Many analysts use above 70 as overbought and below level 30 as oversold.
RSI comes under the category of Leading Indicators as it shows the price momentum and gives early signal for entry and exit. Hence RSI is a momentum indicator or Oscillator. Momentum means the rate of change of price or the speed how rapidly the price is rising or falling. It shows whether the movement of the price is strong or just a weak fluctuation. There are various other oscillators used in technical analysis like Stochastic, Williams %R, MFI etc. Some experts say MFI (Money Flow Index) is a better indicator than RSI because it includes volume along with the price in calculation, but most of the traders prefer RSI. Here is a screenshot of RSI indicator on chart in the picture below. We use Zerodha & Upstox trading platform and all the screenshots of charts given here are on Zerodha web platform.
The formula of RSI calculates the average gains and losses in the closing prices in the last 14 days and returns a data point in a percentage format. Then connecting the data points a linier chart is formed which is the RSI line. The upper end of the band is 100 and below it there is a straight line at the level 80 or 70 which marks the overbought zone. The lower end is 0 and above it a straight line at level 20 or 30 indicates the oversold zone.
How to set RSI in the chart
Click on the Studies or Fx button on the chart and search for RSI, click it and a band with a linier chart will show under the price chart (as shown in the below picture) with default settings. If you want to change the overbought and oversold level and colors then click on the settings icon on the RSI chart and a setup box will appear, there you can change the settings. But you should not change other settings like the period which is 14 by default.
How to trade with RSI
Trend reversal sign by RSI
As you know the RSI indicates the strength and momentum of the stock or underlying asset, it is used to identify any sign of reversal in the trend. When RSI line moves in upward direction it shows rise in price momentum which indicates the uptrend may continue and when the RSI line starts falling downward it shows the momentum is decreasing hence the uptrend is ending and a downtrend may start. It gives buy and sell signals which helps traders to enter and exit positions.
Divergence in RSI indicator
In some cases the price and the RSI indicator moves in opposite directions or in opposite trend then it is called as divergence.
When price is falling in downtrend forming lower lows but RSI indicator is forming higher lows showing uptrend then it is called as Bullish Divergence. It indicates the down trend in price is not strong and may reverse very soon. It gives signal to take fresh positions.
When the price is rising making higher highs but RSI indicator is falling with lower highs then it shows a Bearish Divergence. It indicates the rising price momentum is becoming weak and a trend reversal may happen. It alerts traders to book profits or to exit the stock.
Overbought & Oversold zone in RSI
These are called the extreme zones. When the RSI moves in to overbought zone that is above 80 (or maybe 70) it indicates the rising price due to heavy buying interests has touched its extreme level and may decrease or become stable which gives profit booking signal to traders and the price may fall towards its next support level. And due to heavy selling pressure and fear in the market when price falls rapidly and the RSI moves in to oversold zone that is below 20 (or 30) it indicates the stock has fallen much more, could take some pause and some value buying may happen for which the downtrend may reverse.
But entering in overbought zone always doesn’t means the price will start falling suddenly or after touching oversold zone the price will start to rise, it may remain in these zones for a long time. So we should take position (enter or exit) when the RSI starts reverse move and cross the overbought or oversold line decisively and the direction of the movement (either it is going upward or downward) is important. Also we have to analyze the chart and price action to find out any support and resistance levels to enter and exit. We can use the moving averages or trendlines to identify the trend and support & resistance levels.
Generally when RSI is above 60 the stock is considered as strong and in bullish trend and we may expect rise in price in short term. Hence short term traders like Swing traders or Momentum traders look for opportunities to buy on dips for short term gain.
Stocks whose RSI is moving between 40 to 60 levels may give good Swing trading or Positional trading opportunities. Traders enter when the stock starts moving upward from the 40 levels and exits if it retrace from the 60 levels. This is how RSI indicator gives buy and sell signals for short term trades.
When RSI is below 40 the stock is considered as weak and may enter in to a bearish trend or may consolidate for a long time in the same price zone. Generally short term traders avoid making position in these stocks.
When RSI falls below 30 or 20 and enter in the oversold zone, it shows the stock is in sever downtrend and may continue falling or lag in this zone for a long time. But if it is a fundamentally good stock and fallen due to any short term cause or panic selling then value investors or long term investors consider it a good opportunity to value buy. They add these stocks to their watchlist and regularly monitor them for any sign of reversal in trend and add them to their portfolio for long term gains.
Conclusion – These are some basic strategies and techniques commonly used by the traders but there is no full proof technique in the stock market. And we cannot rely on any one indicator only, we should analyze the price action or may use other indicators like moving averages, MACD, Bollinger Band etc with RSI for better refined indications. This is a short and basic overview of RSI indicator and trading strategies just for education & information of beginners in the stock market, and we all know that investing in stock market is subject to market risk. We should learn to improve our skills & take our own decisions and consult any professional advisor in case we need. Thanks for visiting our page and happy investing.
