Introduction
People who invest in the stock market always want to see their portfolios grow. But the investing game becomes very tricky without proper knowledge and information about the market. Herbert Spencer’s theory of “survival of the fittest” completely fits in the stock market because if you want to make a profit, it will certainly be someone else’s money. So it’s better to be a warrior in a garden than Gardner in a war.
In this article, we will discuss the Relative Strength Index, one of the fundamental aspects of technical analysis in the stock market. J. Welles Wilder Jr. built this concept in 1978. Wilder was an American mechanical engineer who was the father of many other technical indicators like ATR, ADX, Parabolic Arc, and RSI.
Definition
The Relative Strength Index is a momentum oscillator that measures the speed and change of price movements of the stocks in the stock market. If you see the RSI in the chart, you will find it oscillating between 0-100 in a technical graph, and it will not go below 0 and above 100.
There are three essential stages in the RSI chart:
- 30
- 50
- 70
The zone between 0-50 is said to be the bearish zone, and between 50-100, it will be considered the bullish zone. When RSI in the stock market goes beyond 70, it is called overbought, and if it goes below 30, it will be considered oversold.
These days, conventional traders use a range between 30 to 70, and a new generation of traders are using indicators between 40 to 60. Let’s check now how to calculate the Relative Strength Index with the help of a formula.
Definition
RSI= [100/1+RS]
RS= Average of X days up closes/Average of X days down closes.
Calculation
The RSI is calculated during the rise and fall of prices in the stock market. Wilder, the inventor of RSI, used 14 days of RSI, which modern-day stock market traders still use. However, using the 14 days RSI is not binding, and a trader is free to decide the number of days for computing the same.
But the interesting thing is that Wilder, in his book Concept of the Technical Trading System, says losses are suggested as positive values, not negative ones.
Example
Sreesanth has invested in RBI bank stocks. During the 14-day trading period, the RBI stock generated positive returns on the subsequent 9 days and negative returns on 5 days. Sreesanth decided to calculate the RSI and to calculate RSI, and he had to follow the details given down below:
- Sreesanth will calculate the absolute gain in each of the 9 days. He will add the absolute gain he earned for 5 days on his RBI stock and divide it by 14. It will give the figures of average up closes of the RBI.
- Sreesanth will then calculate the total loss in each of the next 5 days on the RBI stock and divide it by 14. It will give the figure of average down closes.
- Now, Sreesanth has to divide the average up closes or gains of the RBI by the average down closes or losses to give us the Relative Strength.
- The figure is further normalized using the above formula of Relative Strength Index for the RBI stock to ensure that it lies between 0 and 100.
Now, let’s do it by figure:
14 days of closing of RBI stock.
|
Date
|
Closes
|
Change
|
Gain
|
Loss
|
Avg. Gain
|
Avg. Loss
|
RS
|
14 day RSI
|
|---|---|---|---|---|---|---|---|---|
|
11th March
|
46.22
|
-0.19
|
|
0.19
|
0.20
|
0.10
|
1.97
|
66.36
|
|
12th March
|
45.64
|
-0.58
|
|
0.58
|
0.19
|
0.14
|
1.38
|
57.97
|
Limitations:
- RSI is not a reliable indicator for most traders. Sometimes the RSI indicators send ambiguous signals, or we call RSI divergence or misleading signals that can lead the traders to a huge loss.
- When there is a strong trend in the stock market, RSI is not going above the mark of 100 on the chart, so you cannot measure the market’s momentum during these times. Hence, it is not reliable.
- There are also incidents with the Traders; when momentum oscillators can move without showcasing any clear trend to the traders, the stock can be overbought or oversold for longer. It might confuse the traders, who cannot make any explicit opinions.
Conclusion
RSI indicator is critical whether you are working in the stock market, Forex trading, Future market, or Commodity market. The RSI indicators are prevalent in a few niches of traders. Though like everything, RSI has its pros and cons. But it can benefit you in short-term trading and even in the long term. You have to understand this Indicator very carefully and correctly.
So this article tried to give an outlook on the RSI indicators so that you can make decisions not completely based on this single Indicator. Still, RSI, along with other technical indicators, helps you a great deal in your stock market investment.
Reference
- https://blogs.threedots.app/post/what-are-the-limitations-of-rsi
- https://www.iforex.in/education-center/rsi-relative-strength-index#:~: text=Here%20are%20just%20a%20few,for%20a%20long%20time%2C%20hence%E2%80%A6
- https://school.stockcharts.com/doku.php?id=technical_indicators:relative_strength_index_rsi
Leave a Reply