1.1 Introduction to Relative Strength Index:
Relative Strength Index most commonly known as RSI was first introduced by J. Welles Wilder in his book “New Concepts in Technical Trading Systems”.
The aim of introducing RSI is to measure the speed and change of price movements. RSI comes under the category of momentum indicators or oscillators. Value of RSI oscillates between 0 and 100.
Traditionally the market/stock tops are identified when the RSI value is above 70 and market/stock bottoms are identified when RSI value is below 30.
Momentum is simply defined as rate of change. In case of RSI we are measuring rate of change of stock/index prices. Rate of change of stock prices tells us when the market is slowing down or when the market is in a trend.
1.3 Formula for calculating RSI:
The formula for calculating RSI is
RSI = 100 – [100 / (1+RS)]
Where RS is the relative strength, and is the ratio of average of previous ‘x’ day’s gains to average of previous ‘x’ day’s losses. In his book “New Concepts in Technical Trading Systems”, wilder has taken the value of ‘x’ as 14 days.
But some short term traders also prefer value of ‘x’ as 9 days and some positional traders prefer it to be 25 days.
When lower number of days is used for calculating RSI, it becomes more sensitive to changes in the price and may sometimes give false signals. While using higher number of days may make the indicator lagging.
1.4. How to apply RSI in trading:
RSI is mainly used in a sideways or ranging market. Values of RSI are used in identifying support and resistances in a chart.
A support in a chart is an area where the selling pressure in a stock comes to an end buying/upward movement starts. Whereas a resistance in a chart is an area where the buying pressure in a stock comes to an end and selling/downward movement starts.
When the RSI value reaches 70, the stock is said to approach its resistance are. Similarly when the value of RSI reaches 30, the stock is said to be in its support area.
In our next article we will look at advanced concepts like divergences.