RSI is a momentum oscillator indicator which means it tracks the recent rate of rise or fall in the stock price movement based on the recent close prices. It is calculated using the following formula:
RSI = 100 - 100/(1 + RS*)
*Where RS = relative strength = (Average of Gains over recent trading period)/ (Average of Losses over same trading period) Gain/Loss = Difference of current close over previous close.
The default time frame to measure RSI is 14 periods. However the same can be lowered or raised to increase or decrease sensitivity. RSI varies between 0 to 100 and the stock is considered overbought when RSI is above 70 or oversold when RSI is below 30. RSI is used to identify oversold and overbought stocks, direction of the trend and thereby trend reversals. Different researchers have come out with various ways to interpret RSI.
Some of the popular ones are as below:
- When RSI crosses 30 from bottom, it indicates bullish confirmation signal and when it crosses 70 from top, it indicates bearish confirmation signal.
- RSI tends to vary between 40 to 80 in bullish market and 40-50 zones act as support and pullback into RSI (40-50 zone) is buy signal.
- RSI tends to vary between 20 to 60 in bearish market and 50-60 zones act as resistance and entry into RSI (40-50 zone) is sell signal.
- Positive Reversal - When stock makes higher low and RSI makes lower low
(not necessarily in oversold zone but could be in 30-50 zone), it signals despite weaker momentum, stock did not make a lower low and therefore shows underlying strength and signals buy.
- Negative Reversal - When stock makes lower high and RSI makes higher high (not necessarily in overbought zone but could be in 50-70 zone), it signals despite stronger momentum, stock did not make a higher high and therefore shows underlying weakness and signals sell.
- Bullish Divergence - When stock makes lower low and RSI makes higher low (with earlier RSI low preferably in oversold zone), thus RSI fails to confirm price movement signalling reversal and thereby it signals buy.
- Bearish Divergence - When stock makes higher high and RSI makes lower high (with earlier RSI high preferably in overbought zone), thus RSI fails to confirm price movement signalling reversal and thereby it signals sell.
- Bullish Failure Swing - When RSI moves below 30, then bounces back above 30 and then pulls back but holds above 30 and then breaks its prior high, it signals buy.
- Bearish Failure Swing - When RSI moves above 70, then pulls back below 70 and then bounces back but fails to move above 70 and then breaks its prior low, it signals sell.
Note: Divergences are found to only lead to brief reversals and therefore to be used with caution. RSI can give wrong signals in very strong trends. So, RSI is best used along with other indicators.