Stock trading is a vast field that comprises numerous tools and indicators to assist traders in their decisions. Another widely used and probably the most popular indicator is the Relative Strength Index or RSI. This effective indicator can prove useful in revealing the current trends in the market and assist the trader in finding good entry or exit points. In this article, you will learn what RSI is all about, how it is computed and how you can incorporate it into your stock trading.
What is RSI?
The Relative Strength Index (RSI) is an indicator that shows the extent of the strength or weakness of the price movements. This indicator was introduced by J. Welles and Wilder Jr. in his book of 1978 New Concepts in Technical Trading Systems. The RSI ranged from 0 to 100 and is used in identifying the over controlling or under controlling of a stock.
RSI = 100 – [100 / (1 + RS)] where RS (Relative Strength) = The average of the last x days’ up closes / The average of the last x days’ down closes.
The common setting for RSI is the 14 periods, but this may vary depending on the trader’s decisions and practices.
How RSI Works
RSI presents a quantitative measure ranging from 0 to 100, which enables traders to establish the force of a stocks price trend. Here’s how to interpret the RSI values:
RSI above 70: This means that a stock might be overpurchased. An overbought condition means that the stock has been in a sharp up move and the rates of rise are slowing down and may reverse or correct.
RSI below 30: This means that potentially a stock may be over sold. An oversold condition implies that for a certain period the stock price has been declining and may be ready for a bounce.
RSI around 50: Level 50 can be considered as the neutral point that shows the stock is neither over bought nor over sold.
Relative Strength Index in Trading Stocks
RSI is a highly effective tool to help in the decision making of trading activities; however, it is paramount to incorporate other analysis techniques and other indicators. Here are some common ways to use RSI in stock trading:
- Identifying Overbought and Oversold Conditions:
In trading, RSI is used to ascertain whether a stock is over bought or over sold. For instance, when the RSI of a stock climbs above 70, it could be a trigger to begin selling or shorting the stock since there is likely to be a pullback in price. On the other hand, if RSI is below 30 it means that it might be an appropriate time to enter the market as a buy because the price may bounce up shortly.
- RSI Divergence:
Crossover happens when the price of the stock goes in the opposite direction of the RSI. This is a strong indication of a possible trend reversal signal. For example, when the stock price is going up but the RSI is going down, it means that the buyers are exhausted and a reversal could be expected. On the other hand, if the stock price is in the downward trend but the RSI is moving upwards it could suggest that the current trend is fading and a bounce up may be expected.
- Support and Resistance Levels:
It is also possible to use RSI to define the levels of support and resistance. In the uptrend, the RSI is commonly above the 30 level and may often reach 70. In the bearish market, the RSI is often found to trade below the 70 line while it often trades near the 30 level. These levels assist the trader to know the most appropriate time to enter or exit the market.
- RSI as a Confirmation Tool:
It is common among traders to utilize the RSI to confirm other technical indicators. RSI and Other Indicators Traders tend to employ RSI to validate other technical analysis indicators. For instance, if a stock is trading above a particular resistance level, and the RSI is also above the 50 level and rising, it would support the breakout. In the same way, if the stock is below the support level and the RSI is below 50 and in the process of falling, it can strengthen the breakdown.
Guidelines on How to Implement RSI in Trading
Combine RSI with Other Indicators: RSI is a very useful tool, but it works best when combined with other indicators, such as moving averages, MACD, or Bollinger Bands. This approach could help give a more balanced picture of the market and thus minimize the chances of the signals being distorted.
Adjust RSI Settings for Different Timeframes: RSI is usually set at 14 periods but the trader might set it to any value that he/she deems most appropriate. Such traders who want to make quick trades may employ a 7-period RSI as a way of identifying quick trends while slow traders who want to look at the overall trend may employ a 21-period RSI.
Be Aware of Market Context: When using RSI, it is important to always look at the bigger picture. In a strong trending market, RSI may stay in overbought or oversold territory for quite a long time. Learning about the market environment will enable you not to rush to trade when it is still not the right time.
Final Notes
The Relative Strength Index, or the RSI, is a single parameter that is useful to stock traders as it gives an understanding of market momentum and possible changes in direction. Knowing how RSI operates and using it in your trading will enable you to improve your prospects of making good trades. Also, as with any other indicator, there are no absolutes in trading, so always trade with the RSI in combination with other tools and always stick to the rules.
