In this article:
- What is a momentum indicator?
- What is Relative Strength Index (RSI)?
- The Concept and Formula to calculate RSI Indicator
- How to analyse overbought and oversold regions
- What is RSI divergence?
What is a Momentum Indicator?The momentum indicator indicates the velocity of a price trend. Basically, it indicates the speed at which the price of a share changes. For example, suppose a stock is trading at Rs 1,000 on Monday. On Tuesday it moves to Rs 1,050 and to Rs 1,100 on Wednesday. This indicates that the stock has a high momentum as it has moved upward by 10% in just 2 days.If the same share would move 10% in two months, then we would say that the stock has a low momentum. Momentum indicator analyses how fast the share price changes.There are several momentum indicators. The rate of Change (ROC) is the most simplest of all. It’s nothing but a percentage change in a stock over a given period. When you plot this percentage change on a chart along with price it becomes the ROC indicator.You can learn everything about Momentum or ROC indicator in this video.
What is RSI Indicator?RSI Indicator was first introduced by J. Welles Wilder in 1978. It is a technical indicator that outlines the strength of a particular share or the index. It ranges from zero to 100.
- If the RSI is above 70 then it signals that the stock is overbought.
- While the RSI value is below 30 then it signals that the stock is oversold.
How is RSI Calculated?RSI is based on the difference between the average closing price of a stock on up days and on the down days. Wilder recommended a time period of 14 days to calculate RSI. It is called a look-back period.Formula to Calculate RSIRSI = 100 – [100 / (1+ Average gain/Average loss)]Here, the average gain is the sum of gains in the past 14 days. The average loss is the sum of losses in the past 14 days.Let’s take an example to understand the concept better.Let’s say a stock is trading at Rs 1,000 on Monday. If on Tuesday the closing price of the stock is Rs 1,004, it means that the stock has gained 4 points. If on Wednesday, the closing price is Rs 1,002 then it has lost 2 points than the previous close.Assuming the previous closing price of the stock was Rs 999. Let’s take a look at the table below.
|Day||The closing price of a stock||Gains||Losses|
What is RSI Divergence?The divergence between the RSI and the share price can often be a useful reversal indicator. But what is RSI divergence?Usually, when we look at an RSI Indicator, it moves in synchronization with the stock price. So, when there is an upward trend, the RSI also moves in sync and vice versa.But sometimes, you might come across situations where the RSI has started to diverge from the stock price.Let’s take an example. As we can see in Dr Reddy’s chart, the stock price is not moving in sync with the RSI Indicator. So, when an indicator disagrees with the price and doesn’t move in sync, it indicates that there might be a trend reversal.Divergences can be of two types.
- Bullish divergence
- Bearish divergence.