Relative Strength Index (RSI)
Relative strength index (RSI) is one of many popular indicators used by technical traders for analysis of financial assets such as Stocks(Equities), Foreign Exchange (Forex) and Cryptocurrencies.
RSI is typically used to attempt to identify overbought or oversold conditions in trading an asset. The RSI is intended to chart the current and historical strengths or weaknesses by analyzing price movement over time.
RSI (Relative Strength Index) – also known as “Momentum” on some trading platforms – measures speed and change of price movements.
It is one of many technical indicators on forex charts used by foreign exchange traders to determine when they should buy or sell currency pairs based on recent changes in their prices.
The indicator fluctuates between 0 and 100 on your chart, with most readings around 30-70. The main idea behind this indicator is to detect the speed of the movement in the market, which tells you if it is overbought/oversold.
It signals when a trend is close to ending. If RSI is near 30, then momentum is slowing down – that’s where traders should think about selling their positions.
When RSI approaches 70, that means it’s an overbought situation, and the price may be likely to reverse. If RSI goes above 70, then trades are probably going against your favour right now.
RSI can also determine if market volatility has increased or decreased because, at extremes (either high or low), this can indicate whether there has been too much speculation resulting in a range bound market or an overreaction that is being corrected.
A high reading means that security can have high volatility and it’s in the oversold zone, while a low relative strength index value shows that the stock may be experiencing a lot of selling pressure.
The divergence between price action and RSI suggests potential trend reversal.
RSI is used in many markets to determine when to close trades with small profits at risk due to changes in momentum/direction.
The first method of computing RSI looks at the rate-of-change of a security’s price. For this example, assume that on May 1st, XYZ stock closed at $10.00 per share.
On June 1st, it closed at $11.50 or 50 cents higher than its previous close or state. The next day, it closed down to $11.20 for a loss of 20 cents from its high point of the past two days, thus ending up only 10 cents above its prior close.
For this example, assume that the RSI on June 1st is at 55, and on May 31st, it was at 45. It would be an indication of solid momentum for XYZ stock.
The stock had a high percentage gain in four days versus a two-day gain for the prior two trading periods. RSI would continue to remain high since each closing price remained above its respective prior close.
The second method of computing RSI looks at how quickly price changes occur within a security’s trading period—the higher the velocity, the more rapid the change in price during that specific period.
Assume that XYZ stock is currently trading at $10 per share on June 5th and rises to $11.60 by June 8th.
It would indicate substantial velocity for XYZ stock because the price increased by 60 cents over two days or 30 cents per day, where each closing price was above its respective prior close.
Momentum + velocity = strength
Combining momentum and velocity helps determine whether RSI is high, low, or neutral.
For example, if the RSI is at 70 on June 1st, which reflects strong momentum but then falls to 50 on June 5th, which indicates that it is losing both momentum and velocity, the overall trend may be considered to be bearish.
Likewise, if RSI moves from 55 on May 31st to 45 on June 1st, indicating loss of momentum, but the rate-of-change or velocity is increasing, RSI would be considered to be in a bullish mode.
When you look closely at how RSI works, its function is simple. A security that has gained 20% over the past month will have an RSI of 80 (according to the first method of computing). When this indicator falls below 60, it may indicate that the price has risen too far too fast.
If momentum continues on this same path and hits 40, then the stock could no longer boast good momentum either—it’s time to sell!