When it comes to analyzing the strength of price movement, the Relative Strength Index, or RSI, is a tool that traders often reach for.
Developed by J. Welles Wilder in 1978, the RSI is a momentum indicator and oscillator, crucial for measuring the speed and change of price movements. Momentum indicators, like the RSI, help traders understand how strong a trend is, while also providing signals about potential reversals by fluctuating between two extremes.
Even after more than four decades since its development, the RSI remains one of the most popular and trusted indicators among traders globally. Its enduring popularity is due to its simplicity, effectiveness, and the valuable insights it provides into market conditions.
How is RSI calculated?
So, how exactly is the RSI calculated?
At its core is the formula
RSI = 100 - (100 / (1 + RS))
where RS stands for Relative Strength and is calculated by dividing the average gain of up periods by the average loss of down periods over a set time frame.
While this formula might seem complex, I won't delve into the detailed calculations here, as that’s beyond the scope of this article. Instead, I want to focus on the practical aspects of the RSI, where its real power lies. However, if you wish to know the details, you can get it at this article on on Macroption on RSI calculation
How is RSI shown in a price chart?
On a stock chart, the RSI is typically displayed as a line beneath the price chart, moving up and down between the extremes of 0 and 100 (see the picture below). When interpreting RSI, certain key levels, like 30 and 70, are particularly significant. Let's explore these levels and understand why they matter.
1. Levels 30 and 70- These are the most commonly referenced RSI levels. When the RSI drops below 30, the stock is considered "oversold", suggesting it may be undervalued. Conversely, when the RSI rises above 70, the stock is said to be "overbought", indicating it may be overvalued.
However, it's important to note that an oversold or overbought RSI doesn't automatically signal a buy or sell opportunity. Stocks can remain in these zones for extended periods, especially during strong trends.
Some traders prefer to buy when the RSI, after being in the oversold region, climbs back above 30 (or sell when it falls below 70). This strategy can be risky if the RSI is used alone.
2. Level 50: The midpoint between 30 and 70, RSI level 50, can be a valuable tool for confirming trend direction. In an uptrend, the RSI typically stays above 50 and frequently touches the 70 level.
Conversely, in a downtrend, the RSI mostly remains below 50, often touching the 30 mark.
3. Levels 60 and 40: These lesser-known levels are also important. In an uptrend, the price tends to accelerate once the RSI crosses above 60, while in a downtrend, the price can drop quickly once the RSI dips below 40. Further in a downtrend, RSI generally doesn't go beyond 60 and in uptrend RSI generally remains above 40.
What is RSI divergence?
While the Relative Strength Index (RSI) is commonly known for identifying overbought and oversold conditions, as well as quantifying momentum, it also has the powerful ability to predict potential trend reversals through RSI price divergences. These divergences occur when the movement of the RSI is in opposition with the price action, signaling a possible shift in the prevailing momentum.
A divergence takes place when the price moves in one direction, but the RSI does not follow suit.
For example, if the price makes a new low but the RSI makes a higher low, this is divergence. This conflict between price and RSI indicates that the underlying strength of the trend may be weakening, putting potential reversal on horizon.
Divergences can be categorized into two types: bullish and bearish divergences.
A bullish divergence typically occurs near the oversold region when the price makes a new low, but the RSI makes a higher low. This situation suggests that the downward momentum is losing strength and indicate a potential reversal to the upside or at least a pullback. This is shown in the image below.
As you can see in image above the price makes a lower low (as shown by blue trendline) but RSI doesn't follow the suit and makes a higher low instead. Notice that the price goes for a northward journey after the divergence.
Conversely, a bearish divergence happens when the price makes a new high, but the RSI makes lower high, often near the overbought region. This signals that the upward momentum may be fading, and a downside reversal or pullback could be imminent. See the picture below which shows bearish divergence.
You can notice in the chart above that price makes a higher high but RSI makes a lower high as shown by blue trend lines suggesting a bearish divergence. Also see that price begins to fall after the RSI divergence.
RSI divergence is a powerful tool for spotting trading opportunities, however, you should exercise caution and not enter a trade solely based on spotting a divergence, as divergences can sometimes fail.
To improve the reliability of trading divergences, it is better to wait until the price has broken out or broken down through a significant resistance or support level.
Additionally, other indicators should be used alongside divergences to validate the signal. Indicators such as Bollinger Band, MACD (Moving Average Convergence Divergence), or ADX can be helpful in confirming the potential reversal signaled by the divergences.
Look at the chart below that illustrates how RSI and Bollinger band combined gives powerful signal.
In conclusion, the RSI is a powerful tool that offers valuable insights into market conditions and potential price reversals. By understanding and using key RSI levels—30, 50, 70, 60, and 40— and by spotting divergences you can better navigate the complexities of the stock trading.
Remember, while RSI is important, it should not be used in isolation. Combining RSI with other indicators, like Bollinger Bands or the 200-period EMA, can provide more reliable trading signals.
Further Reading-
-Relative strength strategies for investing by M Faber
- Relative strength strategies in China's stock market: 1994–2000 by C Wang
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