Relative Strength Index – RSI Meaning
Relative Strength Index popularly known as RSI was developed by J. Welles Wilder as a system for giving actual buy and sell signals in a changing market. RSI in stock markets is often used to identify price tops and bottoms by focusing on key levels (usually 30 and 70) on the RSI chart which is scaled from 0-100.
Relative Strength Index – RSI explained
RSI is based on the difference between the average of the closing price on up days v/s the average closing price on the down days. A time period of 14 days is common, but other periods can also be used.
RSI = 100 – (100 / 1+ U/D)
U = Average of upward price closes (EMA of gains)
D = Average of downward price closes (EMA of losses)
Application of Relative Strength Index – RSI in stock trading
Benefits of RSI: Movements which might not be readily apparent on the bar chart can be easily spotted by RSI. Support and Resistance levels appear can be visible with greater clarity with the help of RSI. Swing failures above 70 or below 30 warn of impending reversal. Divergence between the RSI and price can often be a useful reversal indicator.
Using RSI Indicators for generating Buy and Sell Signals
When RSI line spikes down and penetrates 30 on the Index scale, then moves up, then is followed by another down spike but it is less than the first spike, this is called divergence in this way a buy signal is generated. RSI’s most popular time period is 14 days but a shorter time frame of 6 days can be used for short term trades such as for intraday analysis.
RSI acts as an important indicator of trend reversal as it clearly shows divergences with the price action. In the above example RSI at around oversold levels of 30 shows divergence with the price action in the Bank Nifty. Prices going down but RSI refused to go down is an important reversal signal and the RSI indicator generates a buy signal.
In the above example RSI at around overbought levels of 70 shows divergence with the price action in Jubilant Foodworks. Prices going up but RSI refused to go up acts as an important reversal signal and the RSI indicator generates a sell signal.
Major top in Jubilant Foodworks was precisely spotted by a combination of RSI and other confirming patterns like the double top. RSI above 70 was the first pointer to the overheated stock, then came a fall and a bounce back which did not conform with the RSI which had by that time already started moving lower, giving a clear sell signal.
Like any other indicator RSI has to be used with other confirming signals like trend line penetrations or price pattern breakouts for more reliable and high probability signals.