In this article, we will talk
about the application of the RSI indicator for trading stocks. The relative strength index (RSI) is a popular momentum
oscillator used by traders and investors to identify overbought and oversold levels in stocks and other
financial instruments. It ranges from 0 to 100 and measures the speed and change of price movements.
Oscillators typically perform
well in markets that lock in trading ranges instead of setting long-term trends. This is why using RSI
for stocks can be tricky, as stocks often maintain trends for extended periods. Therefore, using RSI
blindly, or without other technical indicators for stocks may likely result in losses rather than gains.
This article doesn’t provide any
kind of investment or trading advice. Instead, it presents educational material to help you understand
the RSI tool better.
What is the RSI indicator?
The relative strength index
(RSI), is a widely used momentum oscillator for stock trading technical analysis. It was created by
Welles Wilder in June 1978, who detailed its calculation method in his book "New Concepts in Technical
Trading Systems". This type of oscillator is a technical analysis tool that measures the speed and
amount of price changes in a financial instrument. It compares the average gains and losses of a
security over a certain period, helping you determine the asset's strength and weakness.
The RSI calculation is:
RSI = 100 −
(100/(1=RS))
You obtain the relative strength
(RS) by dividing the average number of up closes over a span of X days by the average number of down
closes over the same X-day period. Welles Wilder popularized the use of the 14-day RSI, which is widely
adopted. However, you still have the flexibility to choose the number of days for the computation.
Basics behind the RSI indicator
The RSI indicator oscillates
between 0 and 100. Generally, an RSI reading above 70 suggests that a stock is overbought. This means it
is potentially due for a pullback. On the other hand, an RSI reading below 30 on the price chart
suggests that a stock is oversold. This means it is potentially due for a rebound.
An RSI indicator reversed
to the downside from the oversold conditions area. Source: Tradingview.com
The moment when the RSI crosses
a 70 or 20 watermark, you might consider it a trading signal. However, don’t rely solely on such a
signal to build your trade.
Using divergence may help you
get a clearer picture and a better signal. Divergence is a confirmed signal, meaning it is stronger than
a usual RSI signal (when it crosses the oversold area threshold, for example). Divergence, therefore, is
more reliable and produces a better hit rate; however, it appears more rarely.