Many successful traders credit their profits to the relative strength index of the stock market. Data points and trends known as RSI indicators help them determine when to buy and sell based on the likely trajectory of the market.
What Is an RSI Indicator?
In the stock market, the relative stress index measures the stock market’s rises and falls, expressing the ratio of increases to decreases as a ratio between 1 and 100. When this ratio is at least 70, this RSI indicator shows that a specific investment’s prices have exceeded market projections, while an RSI of 30 or below indicates the opposite situation. The former scenario is called an overbought level, while the latter is known as an oversold level.
The RSI indicator constantly evolves based on the most recent price action for that particular stock. Investors often use this number to confirm trends in the market and determine whether to buy or sell. This type of indicator is called an oscillating metric. This metric is one of several key concepts in technical analysis developed by mechanical engineer turned stock trader J. Welles Wilder. It was first published in the June 1978 issue of Futures magazine, which was then called Commodities.
How Is the RSI Indicator Calculated?
First, you must find the ratio of average up closing days to average down closing days over the time period you wish to measure (represented by N). The standard period for calculating an RSI indicator is 14 days, but you can also use shorter or longer periods to gather various types of information for comparison purposes.
In this relative strength index calculation example, the initial relative strength value (RS) equals the average of the up closing days over the average of the down closing days. Next, this number is indexed to 100 with this formula: 100 – (100/1 + RS) = RSI. Most stock trading tools integrate the option to include RSI on your analysis charts, which makes it easy to compare this data with your other analyses to get a more comprehensive picture that will inform your next move.
A typical RSI in a bull market stays between 40 and 90, so traders should look for support for this indicator in the 40 to 50 zone. In a bear market, RSI ranges between 10 and 60, with resistance from about 50 to 60. As always, these numbers vary depending on the strength of the current market trend and other factors. Extreme levels above 80 and below 20 are rare, but show up when momentum is unusually strong.
How Is the RSI Indicator Useful in Technical Stock Analysis?
If you’ve gotten this far, you’re likely already aware that technical analysis is the process of figuring out what the market will likely do by closely studying what it has already done. Integrating RSI into your technical analysis lets you identify the right time to enter or leave a specific market. Some of the key concepts in learning how to read relative strength index include:
- Understanding the importance of trends. Look for patterns of stock behavior and compare historic actions to your current charts. Study common types of patterns to better predict what might happen next.
- Exploring historical stock actions. For example, if your target stock has been climbing with no signs of stopping, what happened last time that occurred? Did it level out or plummet? The answer will give you a clue as to what to do next.
- Look only at the changes themselves, not at the reason for the change. Technical analysis is designed to reflect all potential market factors without considering the impetus of these factors. Stick to the movement on the charts.
As a stock accumulates more positive closes, the RSI will trend upward. Negative closes result in a downward trend line.
What Are Some Common Effective RSI Strategies?
If you’re wondering how to use RSI, try implementing these RSI techniques as part of your technical analysis:
To find bearish divergence, look for price charges with a slightly higher high than an RSI chart that has begun declining. This RSI indicator is called a reversal pattern and often shows up when an uptrend is about to change direction. Look for several candlesticks with this pattern, then make your move to sell before the price drops.
On the other hand, when the price is at a lower low than the RSI, expect bullish divergence with an uptrend on the way. This might be a green flag that it’s time to purchase an investment that you’ve been eyeing.
When RSI is moving in the same direction as the trend line, it typically shows that the trend will continue. Often, this type of RSI indicator leads to increased momentum.
With positive reversal, you’ll notice an uptrend line with a higher low than the previous price correction paired with an RSI at a lower low than the previous price correction. With a negative reversal, the RSI hits a higher high than with the previous downtrend while the price correction hits a lower high. Reversals usually indicate that the stock will soon rebound to the trajectory of its main trend line.
This four-part indicator is designed to analyze when an RSI may recover from being overbought or oversold. The components of a bullish swing rejection include an oversold RSI that crosses above the 30 indicator, dips without becoming oversold, then breaks its latest high.
A bearish swing rejection mirrors these steps when the RSI crosses above the 70 indicator, dips below 70, crests again without exceeding 70, then dips below its most recent low point. Using this technique can help traders analyze the long-term trends of a specific investment. Keep in mind that the 30 and 70 indicators are just guidelines. Once you become more experienced with this technique, you may find that 20 makes more sense to you as a red flag that a stock is oversold.
As an RSI line increases, connect at least three points to create an uptrend line. Do the same when the line is headed downward to create a downtrend line. Reviewing these trend lines provides information about the stock’s next steps. When a trend line breaks, it often indicates either a reversal in prices or a continuation. Check for a break on a price chart trend line when you see this RSI indicator to take advantage of a significantly early trading opportunity.
The RSI can also be used for trend confirmation, particularly when extended to time periods beyond the 14-day standard. When the RSI passes 50 while the trend line is negative, this often confirms a bullish trend. A bearish trend is confirmed when the trend line is positive but the RSI drops below 50. Remember that RSI is most useful in a ranging market, but can provide misleading signals in a trending market.
Look at an investment’s RSI over a short period, such as five, as well as over the default long period of 14. Look for occasions in which these two lines on your chart cross over one another. When the 5 line rises higher than the 14 line, this indicates a good time to buy since prices are likely about to increase. When the 5 line crosses the 14 line and dips below it, this indicates price decline is on the horizon. Many successful investors take advantage of this strategy in conjunction with pivot points.
Like other types of market indicators, the RSI is most useful when viewed in combination with other charges and data to create a full picture of the stock in question. RSI is considered a leading indicator, which means it requires confirmation from different indicators that do not account for momentum. False indicators can often lead inexperienced traders astray. RSI tends to be most accurate in a market that is currently swinging between bullish and bearish tendencies.
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