While trading, price changes are the key points that determine the profit or loss any trade is posited to achieve. Therefore, traders are keen on the factors that affect price changes and, where possible, predict these situations.
One such tool that traders employ when figuring out changes in price is the Relative Strength Index or RSI. J. Welles Wilder developed the Relative Strength Index indicator in his classic hit, ‘New Concepts in Trading Systems.’
Today, the index serves traders who leverage it when analyzing a stock chart and can add great value to any trading strategy. Read on to find out how you can employ this tried and tested tool and succeed in your trades.
What Is RSI And The Role It Plays In Technical Analysis
RSI is a tool used in technical analysis to indicate a stock’s momentum. A stock price usually follows a particular trend where it will experience periodic rise and fall. The momentum, therefore, is how fast the price appreciates or depreciates over time.
Throughout the history of trading, great importance is heaped on technical analysis. Through it, traders have been able to study previously recorded data, compare and contrast with the present, and make a prediction on what will happen in the future. Trading is all about foretelling what might happen so that as you invest your money, you will be confident of the returns.
Historically, markets across the globe witness more instances of growth more frequently as opposed to a downward movement. This trend has proved the importance of monitoring price momentum, more so when focusing on rising markets.
The speed at which the value of a stock goes up is a critical indicator of the strength of its price. As a trader, you need to gauge the prospects of an upward trend in the price of a stock. The RSI indicator provides suitable signals on bullish or bearish momentum in the price. The momentum, therefore, provides an appropriate reference point when analyzing data on the price of a stock or commodity.
While trading, frequent market assessment is crucial. Things move fast across global markets, and to be in business, you ought to be in the know every day. Relative Strength Index indicator is often employed in technical analysis to give you vital information on how the market behaves.
Armed with this data, you will then have a better understanding of the general market environment. Furthermore, knowledge of the market’s behavior should assist you in identifying the best possible investment opportunity to invest.
Unique Features Found In RSI
The RSI formula is capable of assessing price momentum and, as such, is a favorite among technical analysis traders. It has a couple of unique features that allow it to work so well to identify overbought or oversold conditions in the market.
1. Oscillation
Traditionally, the RSI indicator is classified as an oscillator indicator. We draw this depiction from oscillators which follow a band but deviate periodically within the band. This deviation may usually occur between pre-defined points or above and below a centerline.
RSI is typically set to move within 0-100 as it indicates overbought or oversold market conditions. Above 70, an overbought market is happening or occurred, and the opposite holds when the figure falls to 30 or below.
2. Centerline crossover
There are two types of centerline crossover; a rising centerline crossover and a falling centerline crossover. Centerline crossovers are necessary market signals indicative of either bullish or bearish market development.
In the case of a rising centerline, the RSI value crosses the 50 line as it nears the 70 line on the scale. Beyond this, market conditions are point to an overbought scenario. On the other hand, a falling centerline crossover lies below the 50 line but only until it reaches the 30 mark. As it moves beyond the 30 line, an oversold condition is the main takeaway.
3. Relative Strength Index Divergence
This occurs between the Relative Strength Index and the price of the trading option. Such a movement indicates that a reversal of market conditions is about to take place.
The two primary types of divergence are Bearish and Bullish divergence. In the former, the price attains a new high as RSI stands at a much more diminished high point. As such, traders use it as a sell sign. The reverse happens when the price falls to a new lower level but RSI maintains a slightly higher low level. As such, the latter urges traders to buy.
4. Positive-negative reversals
Positive-negative reversals differ completely with Relative Strength Index divergence and, as you will see, are the exact opposite of the latter.
A positive reversal points to a sustained increase in the price of a commodity. This will appear where the trading item attains a higher low, so to speak, and RSI realizes a much ‘lower low.’ This lower figure lies between 30-50.
The negative reversal on the other hand, operates in defiance of positive reversals. An instrument will attain a weakened high level as the RSI climbs to a much more significant position. This ‘higher high’ falls between 50-70 lines. Notice that the negative reversal doesn’t crossover to overbought territory. Contrary to a positive reversal, negative reversal indicates a continued decrease in the price of an option.
Generally, price reversals exhibit, once the price performs better than momentum and this feature is seen in specific trends. Traders can then utilize them to confirm a trend.
Why Traders Opt To Use RSI
RSI indicator is a trade favorite among traders, more so technical analysis traders. Most do not use it as a standalone indicator but rather combine it to form part of a greater trading strategy, and here is why:
1. RSI recognizes overbought and oversold market conditions
Like the Stochastic indicator, Relative Strength Index can be used to point out highs and lows depending on whether the market is overbought or oversold. Such parameters are essential when you want to know when the price will likely go up or fall.
The Relative Strength Index scale runs from 0-100. An overbought market is indicated by readings of 70 and above, while an oversold one will entail readings at 30 or lower. When the market is oversold, traders interpret this to point to a likelihood of the price strengthening. With oversold conditions, you are presented with an opportunity to buy into the market as the declining trend is likely to reverse.
During overbought situations, the probability of currency prices to fall is high, and hence the inclination to sell on this signal.
2. Traders use it to locate centerline crossovers
Locating the centerlines is a crucial step to figure out the general trend. Any movement originating from below the centerline (50) upwards shows that the trend is on an upward trajectory, and its strength is similarly on the rise. This is often considered a bullish signal only until it reaches the 70 line. On the other hand, a falling trend follows a movement from beyond the 50-line heading down until 30.
3. Verifies the formation of trends
One of the reasons RSI is popular is because it confirms trend formations in trading prices. For starters, one needs first to ascertain the position of Relative Strength Index. Does it lie above or below the 50 mark?
Typically, there may be an early indication of a downward trend forming. However, you should first wait until the index crosses the halfway point to confirm the trend. The reverse holds for the formation of an upward moving trend.
Limitations Of RSI
Relative Strength Index primarily indicates momentum and can stay in overbought or oversold conditions for extended periods. This may occur when the asset in question has a significant movement in a specific direction. As such, RSI would need a market that fluctuates periodically between bullish and bearish situations. When such a market indicates a strengthening trend, the RSI then loses its usefulness.
Technical analysis tools like Relative Strength Indexrely greatly on available data to give trading signals more so when considering long-term moves. These signals are therefore relied upon when they match a long-term trend in the market. Moreover, the RSI formula uses 14 periods as standard so it would not favor day traders.
False reversal signals come as frequently and can sometimes be difficult to distinguish from accurate signals. For instance, a bullish crossover resulting in a declining stock is a false positive.
The Takeaway
The Relative Strength Index indicator is a powerful technical analysis tool that traders can utilize to aid their trades. While it is not the single best indicator you can find, the mechanisms surrounding RSI are potent and feature prominently among technical analysis traders.
For newbie traders, it seems instinctive to quickly jump onto the Relative Strength Index trading bandwagon before adequately understanding how to interpret an indicator correctly. Remember, the RSI might throw a false positive and mislead your trade. Therefore, patience is essential as you should first have a thorough understanding of such technical analysis tools.
Relative Strength Index, once understood, has the potential to provide you with signals for when the market is ripe for trade. By signaling overbought or oversold conditions, traders will be able to gauge the general market environment allowing them to understand the strength of the price movement to consider trading for the long-term.
Nevertheless, Relative Strength Index should not be your sole indicator but rather complement your existing trading strategy. Traders, more so beginners should first run RSI strategies on a demo account before getting the real experience on a live account.
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