How to Interpret RSI
T echnical analysis is an important aspect of any trading strategy because it can provide you with incredible insight and guide your investment decisions. The RSI of stocks can be used in a number of strategies, making it a key asset in a wise investor’s arsenal. Keep reading to discover what the relative strength index is, how to calculate and interpret it, the trading strategies that use an RSI indicator, and some of its limitations.
What Is a Relative Strength Index?
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The relative strength index, or RSI, is used in technical analysis as a momentum indicator to assess a stock or asset’s overbought or oversold conditions by measuring its most current price changes.
In 1978, J. Welles Wilder Jr. first introduced the RSI indicator in his book, “New Concepts in Technical Trading Systems.” Since then, RSI has become a widely used analysis tool in the world of trading. The relative strength index uses an oscillator, which is a line graph that shows two extremes, with a reading range from 0 to 100 to display its information.
Traditionally, values that meet or exceed 70 are believed to be overvalued or overbought, indicating a potential price drop or trend reversal in the near future. Conversely, if an RSI has a reading of 30 or less, it signifies a condition that is either undervalued or oversold.
Calculating an RSI
There are two components to calculating the relative strength index. To start, investors follow this formula:
RSI (step one) = 100 – [100 / (1 + (average gain / average loss))]
In this calculation, the average gain and loss is represented by an average percentage for a specific period. It’s important to note that the average loss is used as a positive value for this formula. Generally, the initial RSI value is calculated using 14 periods, typically days. Once 14 days of data is available and the first half of the calculation has been completed, the second part of the formula is ready for calculation.
RSI (step two) = 100 – [100 / (1 + ((previous average gain * 13 + current gain) / (previous average loss * 13 + current loss)))]
After investors calculate the RSI using these formulas, they then plot the data using an RSI line below the price chart of an asset. This line graph rises with the size and number of positive closes and drops with the size and number of losses. Because the second part of the calculation effectively balances the results, you really only ever see an RSI get close to 0 or 100 when a market is experiencing strong trends.
How to Interpret the Relative Strength Index
To make sure that the RSI indicator’s readings are appropriately interpreted, it’s important that you are aware of the asset or stock’s primary trends.
For example, if a stock is experiencing a downtrend, the RSI might peak closer to 50% than 70%. In this instance, applying a trend line can help investors more effectively identify bearish conditions. Additionally, evaluating the trading techniques and signals that align with a trend can be helpful. Put simply, the relative strength index can cause some false alarms if investors don’t apply bearish signals when the price is experiencing a more bearish trend and bullish signals when a stock is in a bullish trend.
RSI vs. MACD
Another momentum indicator is the moving average convergence divergence, or MACD. While the relative strength index is used to show whether a security is oversold or overbought relative to its current market price levels, the moving average convergence divergence shows the connection between a security price’s two moving averages.
To calculate the MACD, investors subtract an exponential moving average, or EMA, for 26 periods from the EMA for 12 periods. The difference is then plotted on a graph, giving them the MACD line. The MACD’s nine-day EMA, known as the signal line, is then taken and plotted on the same graph as the MACD line.
Investors use the MACD line and the signal line as a way to evaluate whether they should buy or sell a security. For example, if the MACD goes above the signal line, it may be a signal to purchase a security, while they may choose to short, or sell, a security if the MACD drops below the signal line.
In other words, the RSI evaluates the change in a price using its most recent highs and lows, while the MACD assesses the connection between two EMAs. Analysts often use these two indicators in tandem to get a more comprehensive market analysis. Though both the RSI and the MACD measure an asset’s momentum, they evaluate different factors, which can sometimes result in indications that contradict each other.
Trading Strategies Using a Relative Strength Index Indicator
You can use the RSI to improve your trading by adopting some techniques during your technical analysis, such as:
You can use the RSI to spot bullish or bearish divergences by evaluating whether changes in an asset’s price are higher or lower than what is shown on an RSI chart. This can help you make decisions on when is the best time to purchase or sell an investment. For example, if you notice an asset’s price is hitting lows that drop below even the lowest indication on the RSI, you might interpret this as a bullish divergence and expect an uptrend in the near future. This information could signal an opportune moment to buy an investment you’ve been considering.
Convergence occurs when the RSI and the trend line are heading in the same direction, and it often means that the trend is likely to continue along that path with increased momentum.
Reversals are often an indication that a stock is about to return to its normal trajectory and primary trend line. When a stock is experiencing a positive reversal, you usually see an RSI with lows that dip below the recent price correction along with an uptrend line that has a low that’s a bit higher than the recent price correction. Conversely, a negative reversal usually shows a price correction hitting a lower high than with the recent downtrend and an RSI that reaches a slightly higher high.
Swing rejections use four different variables to evaluate when an RSI can be expected to recover from being oversold or overbought, so they are often used by traders to evaluate an investment’s long-term trends. A bullish swing rejection would consist of an oversold RSI that exceeds 30 on the indicator, dips back down without being considered oversold, and then exceeds its most recent high.
A bearish swing rejection, on the other hand, occurs when the RSI rises above 70 on the indicator, drops back down below 70, rises slightly without crossing above 70, and then dips lower than its current lowest point.
Trend lines are used to gain information about a stock’s possible next movements. You can create trend lines by connecting three points as the RSI line either increases or decreases, giving you an uptrend line and a downtrend line. When a trend line breaks, it usually means that there is either going to be a continuation or reversal in the prices. This can provide an early signal for a possible trading opportunity.
You can also use the RSI to confirm trends, especially when using more than 14 days to evaluate them. If the trend line is negative and the RSI goes below 50, this usually means the stock is in a bullish trend, while a bearish trend can be confirmed when the RSI dips below 50, but the trend line is positive.
Challenges of the RSI
Though the RSI is an incredibly helpful analysis tool in trading, it comes with its share of limitations, such as:
- As with a majority of technical indicators, a relative strength indicator’s signals are most useful and reliable when they align with long-term trends.
- With an RSI, it can be difficult to distinguish false alarms from true signs of trend reversal. Signs of reversal are rare and are sometimes confused with bullish or bearish crossovers, followed by a sudden change in the stock’s movement.
- The relative strength indicator is really most beneficial when used in an oscillating market with an asset that’s price fluctuated between bearish and bullish movements. This is because the RSI shows momentum, meaning it can stay oversold or overbought for an extended period of time if an asset doesn’t experience enough movement in any particular direction.
Aside from learning how to calculate and utilize the RSI, there is a wide range of techniques and strategies that can make you a more successful trader.