RSI (Relative Strength Index) is a technical momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. This indicator is an extremely popular. It is calculated using the following formula:
RSI = 100 – 100/(1 + RS*)
*RS = Average of x days’ up closes / Average of x days’ down closes. RSI calculation is based on 14 periods, which is the default.
RSI oscillates between zero and 100. Traditionally, RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend.
How to use Relative Strength Index (RSI)
While a price moves, RSI traverses somewhere between 0 and 100. Such is the formula that the value of RSI can never breach these two boundaries. In the best and worst cases the value can stick to these boundaries for some days or even months (mostly in the cases of penny stocks).
For technical analysis, we primarily consider 30 and 70 levels. These are the boundaries of technical predictions in RSI context. Anything below 30 or above 70 is out of TA domain.
Above 70 its called overbought and below 30, oversold.
People often come to a quick conclusion and start trading with “short at 70 and long at 30” mindset which looks to be working pretty well on historical data and soon realize that what looked good historically didn’t work very well at all.
So, how do we act when a stock is weakening and RSI is approaching 30. Lets say in some stock yesterday the RSI was 35 and Stock takes another sharp dip today and RSI reaches 32 near closing time. It is still not a buy. Chances are tomorrow it may or may not be oversold and go below 30. So, we will again watch it the next day.
The idea here is to avoid any risk which may not follow market forces in our favour. So, there can be several cases.
1. RSI just holds above 30 for greater part of the session. Here we can think of going long in small. But there should also be an alert and stop if it doesn’t hold and falls below 30. In that case we are out with minor loss. We will wait for RSI to come above 30 again for a possible long. The loss may repeat several times if it behaves erratically until the session is closed above 30 with a long position in our hand but, it still has some dangers involved.
3. RSI holds above 30 and there is no major buying visible in the stock. We will let the session end without making any position. Next day the new candle starts forming, prices are a little up and RSI looks to be turning up. Making longs at this condition has highest probability of success. This is also the most conservative approach applied by most of the traders most of the time.
3. RSI breaches 30 its value is 28, 26 or anything below 30. Absolutely no buying. people often buy on these levels in anticipation of an upside. This is quite dangerous as downward price movement is sharper under 30. That’s why it is called oversold. Everybody is selling and getting rid of it. No buying at all. RSI may turn up from under 30 values hitting 30 and falling again n again. Stock will keep forming new sharp lows every time it repeats that. Finally, when RSI closes above 30 some day, it will be a good time to go long.
The idea is simply to be a buyer only when RSI seems to be taking support at 30 and turning up or to buy when it has traversed under 30 and comes above 30. Closing above 30 is important.
Same is applied when RSI goes to 70. The time frames which are universally looked for these are monthly, weekly, Daily, 4H, 1H, 30min.,15min. and 5minute. Monthly and weekly for medium term, Daily – short term, 4H – intra to couple of days, 1H – 5minute for intraday. A rough idea basically. If in larger timeframes it is overbought or oversold then trading in lower time frames should be avoided unless one is more experienced.
Another very important level is exactly the mid point of 30 and 70 which is 50. Sometimes stock may(or may not) reverse from 50 and we need to apply the same technique making a decision near 50 level.