RSI: Simple yet Powerful Technical Indicator

By November 7, 2014 Trading 3 Comments
RSI: Simple yet Powerful Technical Indicator

It is often observed that traders tend to be attracted towards building complex strategies that process a huge set of instructions built into their algorithm. Several books are read on statistics, technical analysis, fundamental analysis, algorithm building etc. that promise winning strategies.

Technical Indicator for stock trader

All this to find that perfect market entry and exit for our trading system. What happens is that we get so over awed by this ever growing, huge rock of knowledge aka the complex trading strategies and in this process forget that most successful traders of the past had no technical indicators at their disposal and based their trading decisions solely on their feel of the price action. Not that I am endorsing such a strategy, since we live in a world of technology upheaval and we might as well use tools that ease our decision making, but then we only need tools that facilitate the decision process by giving us a good understanding of the market. Complexity in a strategy should not be added to give us a false relief or comfort simply because, as much as we want to, we refuse to admit that money can be made by using one indicator as well.

Having said that, I want to use this space to explain one of the most useful momentum technical indicator: RSI that gives you a good feel of the price action in the market.

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Also Read : Dow theory’s six basic tenets

RSI: Relative Strength Index: First thing to note is that relative here does not compare the stock price to another stock price, but its own stock price over the chosen period.

It takes into account the total profit in the chosen period and divides it by the total loss. The chosen period that we refer to is a parameter that can change for different markets, but most popularly the period is chosen to be 14. So for example: A 14 period RSI looked on a daily chart will add all the profits that have accrued over the last 14 trading days and divide it by the sum total of the losses in the same period. This is called Relative Strength ratio (RS). However, the ratio could take any range of values and it could become slightly difficult to understand whether the same is high or low, the ratio is normalized to produce the relative Strength Indicator (RSI).

RSI = 100 – 100/(1+RS)                                            RS –> Relative Strength

Thus a rising RSI should give a bullish trader / investor confidence in the trend as it tells him that the margin between gains and losses is increasing over time. Similarly, a decreasing RSI should be a good indicator for a reversal of the bullish trend. This leads us to the concept of Divergences.

Bearish Divergence: Rising stock price with falling RSI –> Margin between gains and losses is shrinking –> Decrease in bullish momentum –> Likely fall in prices

Bullish Divergence: Falling stock price with Rising RSI –> Margin between gains and losses is widening –> Decrease in bearish momentum –> likely rise if prices

This concept can be visually seen in the GBP/INR chart below:

RSI Indicator

The chart shows us a set-up of a bearish divergence (Price — Higher High and RSI — not a higher high) and gives us a sell entry at the break of the swing level.

Since the trade signals generated out of these divergences could be plenty as there would be slight divergences here and there every now and then, in order to pluck out the strong signals, RSI is classified into 3 ranges: Overbought, Normal and Oversold. The classification of these levels is done purely on experience and can vary for different markets.

For example: For the nifty Index, an RSI level of 70 and above is classified as Overbought and  a level of 30 and below is classified as Oversold.

For specific stocks, these levels are 80 and 20. However for extremely volatile stocks, levels of 90 and 10 are not uncommon.

The chart above gives another trade that could be obtained from the RSI indicator. Often a fall (Rise) of the RSI to an oversold (overbought) level in an uptrend (downtrend) gives us a likely entry in favour of the   existing longer term trend.
However, since the RSI can have a tendency to remain in the oversold or overbought region for quite some time, entry points are generally coincided with an important support(resistance level) or any key reversal area. We can see in the chart that the trend is that of a bullish one. The most recent RSI is near the oversold region. Also the price is not very far from the long term trend line, which if touched could prove to be a highly secure entry point from the buying side.

Apart from bullish, bearish divergences and trend trading signals, The RSI also provides trend continuation signals (similar to trend trading signals). These are known as hidden divergences in the market and are often used by seasoned traders with wealth of experience.

Also Read : Is the Market Over-Valued?

The gist of the hidden divergences is as follows:

Hidden Bullish Divergence: Forms when price is making higher low, but the RSI is making a lower low. Occurs when there is a retracement in an uptrend.

Hidden Bearish Divergence: Forms when price is making lower high, but the RSI is making a higher high. Occurs when there is a retracement in a downtrend.

Needless to say that the RSI divergences (regular or hidden)are just trade set ups and need to be coupled with separate analysis on market entry and exit points.

Thus as you can see, RSI is a powerful tool to analyse possible entry and exit setups especially during the current phase of extreme bullishness in Nifty, where most traders are either waiting for a sharp correction (which might not happen in recent future) or are diving in at extreme high levels that can lead to rapid capital erosion.

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