Relative Strength Index (RSI) is an oscillator which was developed by J Welles Wilder. RSI is an oscillator which tells an investor about the momentum in an underlying asset. The value of RSI lies between zero and one hundred.
Relative Strength Index informs you about the overbought and oversold levels which means that if the value of oscillator is above 70 then, the following asset is overbought.
Similarly if the value of RSI is below 30 then, the following asset is oversold.
Relative Strength Index can both act as a lagging and leading indicator. In a logical way it is a lagging indicator since it gets formed after the price moves and changes but it can also be used as a leading indicator.
Formula To Calculate Relative Strength Index
The value of Relative Strength Index can be calculated by using a formula.
Relative Strength Index = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change )]
Using this formula an individual can calculate and find the value of an asset, whether the stock is an overbought zone or oversold.
Of course, there are other values also which try to support the price during a trend. For example, when an asset reaches its 50 value then the following levels try to support the price. This example was based on my personal experience that generally price reacts to this level this is not factual.
How to Use Relative Strength Index?
In order to understand how to use Relative Strength Index, I am assuming that the basics of RSI are clear to you.
First and the very basic way to use RSI is to look for overbought and oversold zones. Once you get to identify these zones then the second step is to look at how price is changing and look for important key areas on the candlestick chart.
Let’s assume that a stock is at its overbought zone and the candlestick chart has approached a resistance and the candles are exhausted. Once a candle starts to fall or it creates a bearish pattern then you can enter in a short position placing your stop loss above the key level.
Let’s say that the price is at its oversold zone and the candlestick chart has approached a support or a demand area and the candles at that area are taking a reversal from there. Then, you can enter in a long position once price creates a bullish pattern.
The above method was a very basic way to enter into a trade using Relative Strength Index but there is also a difficult and advanced way to enter but before that you need to understand about divergence and how to identify them.
Divergence in Relative Strength Index and How to Trade Them?
A divergence is when the price of an asset is in a following trend but the RSI shows a opposite momentum.
Let’s try to understand this using an example, suppose the price of an asset is in an uptrend and it’s continuously increasing without showing any exhaustion and the value of RSI is in an overbought zone.
Let’s say the value of RSI starts to decrease with a slow pace while creating a Lower Low (LL) and Lower High (LH) structure but the price is still increasing. This kind of situation is indicating a loss in momentum.
This loss of momentum in any asset indicates that the price is reaching a stage where price cannot increase anymore and there is a probability that price might correct from there.
Similarly, in case of a downtrend price of an asset is in a downtrend and it’s continuously decreasing without showing any exhaustion and the value of RSI is in an oversold zone.
Assume that the value of RSI starts to increase with a slow pace while creating a Higher High (HH) and Higher Low (HL) structure but the price is still decreasing. This kind of situation is indicating a gain in momentum.
This gain of momentum in any asset indicates that the price is reaching a stage where price cannot decrease anymore and there is a probability that price might correct from there.
Conclusion
In the end I would conclude this article by saying that making money from the stock market is surely a challenging task and to make that journey a bit easy is by using indicators. Relative Strength Index (RSI) might help you to identify opportunities but remember that mastering price action is essential which will make you profitable in the long term. Indicators are used to get more confirmations for a trade but the primary and the most important thing in the stock market is the price of an asset.