When it comes to trading, one of the most important things you need to know is how to read charts. Charts are pictorial representations of a stock’s price movement over span of time. It can provide valuable insights about the market’s behaviour. Relative Strength Index (RSI) is one of the most popular and most basic indicators used by traders. In this blog, we will describe what is RSI? How it works and how it is useful in taking better trading decisions.
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What is RSI?
The Relative Strength Index (RSI) is a technical indicator that provides insight about security’s price action. Originally, RSI was developed by J. Welles Wilder in 1978. It is one of the most widely used indicators in the trader community. The RSI is a momentum oscillator that ranges from 0 to 100 and is used to identify the overbought or oversold conditions for any selected security.
How does RSI work?
The RSI is calculated using the following formula:
RSI = 100 – (100 / (1 + RS))
Where RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame.
The RSI is typically represented on the chart as a line that oscillates between 0 and 100. When the RSI is above 70 is considered as overbought. When RSI is below 30 is considered as oversold.
How to use RSI on a chart?
To use RSI on a chart, first we need to select the time frame parameter. The most common time frame is 14 days but one can choose any time frame as per their trading style. After appropriate time frame selection one can add the RSI indicator to your chart. On almost all trading platforms, one can find the RSI indicator under the “Indicators” or “Studies” tab. As soon as one added the RSI to the chart one can see a line oscillating between 0 and 100 range.
Which chart to observe? When?
It totally depends on the person’s perspective of investment. If the person is looking for a swing trade for a month or so, one should observe daily and weekly charts. If the person is looking for trading insights/ shorter period of time like a week or 10 days, one should observe hourly, two hour, four hour charts. And if the view is for intraday, one can go for shorter time like 5 minutes, 15 minutes charts. RSI works best with every other indicator and helps improving the decisions of entry and exit.
Interpreting RSI on a chart
Most commonly used standards are 70 or above level signify the overbought condition and 30 or below level signify the oversold condition of particular security/stock. However these levels are not the only parameter, other complimentary indicators also being used by traders while looking at particular security/stock.
It is mostly used as one of indicator for Trend reversal. For example, if the RSI value is overbought, it means that the security trading happening at a high price for an extended period. The concern security may be due for a correction. The “time to SELL!” signals. Likewise, when the RSI is oversold, it means that the security trading at a low price for an extended period. The concern security may be due for a rebound. The “time to BUY!” signals.
Conclusion
The Relative Strength Index (RSI) is really powerful tool that can help traders to identify approaching or prevailing overbought and oversold conditions for given security. By using the RSI indicator on a chart, traders can potentially identify buy and sell signals, so overall better trading decisions. With practice and experience, traders can develop the proficiency in using the RSI indicator. The RSI indicator is never used in isolation but should be used in conjunction with other technical indicators which are always backed by fundamental analysis.