As a momentum oscillator, Relative Strength Index (RSI) analyses the speed and change of price movements in a stock to indicate whether it looks ‘overbought’ or ‘oversold’. In simple words, being overbought means a stock is overpriced. An asset can be called overbought if it starts trading much above its calculated value.
The biggest struggle for any trader is not to get caught in a market trend at the wrong time, just when the reversal is around the corner.
Often it is seen that buyers rush towards an asset when it is rallying, or sellers start dumping a stock as soon as a sell-off is triggered. In this rush, it gets difficult for traders to assess whether a security is ‘overbought’ or ‘oversold’?
This is when the Relative Strength Index, popularly known as RSI, comes into the picture. In technical trading, RSI helps the traders to assess the strength of a stock and the momentum.
RSI is essentially a popular momentum oscillator used by traders. Now what exactly is momentum oscillator? A momentum oscillator is basically a technical analysis tool that is used to identify the strength or weakness of a particular trend in the market.
As a momentum oscillator, RSI analyses the speed and change of price movements in a stock to indicate whether it looks ‘overbought’ or ‘oversold’.
What do ‘overbought’ and ‘oversold’ mean?
In simple words, being overbought means a stock is overpriced. An asset can be called overbought if it starts trading much above its calculated value. Similarly, when the asset trades lower than its perceived fair value, it is said to be oversold.
When a security is considered overbought, a price correction is likely to follow. In that situation, traders should start selling the security before the market becomes unfavourable for them.
If the security is being seen as oversold, it is time for traders to take fresh long positions in the asset.
RSI, therefore, helps traders determine the correct levels to exit or enter a security when it is caught in an upward or downward spiral.
How is RSI calculated?
The value of RSI fluctuates between 0 and 100. Any value below 30 indicates ‘oversold’ conditions, while value above 70 hints at ‘overbought’ situations.A value of 50 indicates a balance between bullish and bearish positions and is considered a ‘neutral’ condition.
Simply put, an RSI reading below 30 can be interpreted as a ‘Buy’ indication for a stock, while that above 70 can be seen as a ‘Sell’ signal.
Formula to calculate RSI
The average time period used to calculate RSI for a security is 14 trading days. Let’s say a stock was up in 10 of those days and down on the other 4. Then, as the first step to calculate RSI, the average daily gain for those 10 days should be divided by 14. This would give the ‘initial average gain’. Similarly, the average loss of 4 days should be divided by 14, which would give the ‘initial average loss’.
In the second step, you should calculate the relative strength (RS) which is the ratio of initial average gain and initial average loss.
RS = Initial Average Gain/Initial Average Loss
Once you have got the RS, you can calculate RSI using the following formula:
RSI = 100 - (100/1 + RS)
This calculation will give you the first RSI for your stock. You can also build the RSI chart further using subsequent closing prices of the stock after 14 days.
To calculate the second RSI for the stock to build a graph, you will need an extra closing price for the stock, which would give you a new average.
New average gain = [(previous initial average gain) x 13 + current daily gain]/14
New average loss = [(previous initial average loss) x 13 + current daily loss]/14
Once you have got new averages, recalculate the Relative Strength and get a second RSI value using the same formula. This way, you can keep building the RSI chart.
What are the limitations of RSI?
Momentum oscillators like RSI do not take into account any change in the fundamental conditions of the stock. All estimates of being overbought or oversold just depend on the price action.
Let us suppose that the share price of a company is falling day after day due to an adverse policy change by the government that will drastically affect profitability, Now, RSI might indicate that the stock is ‘oversold’, when actually the share price is just adjusting to the new estimated earnings.
Hence, traders should ideally depend on RSI only when fundamental factors are not at play.
Also, it is not advisable to rely on RSI indications during a bull or bear market, when there is broad-based selling or buying across all sectors and stocks, as the values may become erroneous.
To sum up
The Relative Strength Index, or RSI, can prove to be an extremely useful momentum indicator for day traders to get reliable ‘buy’ or ‘sell’ calls if used wisely in combination with other momentum oscillators. Along with the RSI, the traders also take into account the fundamental analysis of the asset.
