Investors are always trying to gain an edge over the market, and a popular way is to apply economic metrics to the stocks they like - before pulling the trigger and buying them. And one of the most effective market measurement metrics – is the Relative Strength Indicator.
The Relative Strength Index (RSI) was developed by J. Welles Wilder Jr. and introduced in his 1978 book, “New Concepts in Technical Trading Systems.” RSI is a great way to measure a stock's potential. The better you understand how RSI works, the more you can start benefiting from one of the most underrated but influential stock market calculation tools available.
What is RSI?
The relative strength index (RSI) is a momentum indicator used in technical analysis that examines the size of recent price fluctuations in order to determine if a stock or other asset is overbought or oversold. RSI is displayed as an Oscillator (a line graph that oscillates between two extremes) and can be read in increments of 0.0 to 100.
Simply said, the relative strength index (RSI) compares the recent performance of a certain stock to its price history performance by combining the average gain or loss that a particular investment has seen over a predetermined time period. The relative strength index (RSI) is typically used by investors to determine if a company is oversold or overbought.
What is the Oscillator?
To understand RSI, we must understand the oscillator model and its work. In stock market terms, an oscillator is a technical analysis measurement metric that weighs a stock's performance between two extreme points (i.e., low purchase points versus high purchase points). The oscillator model is handy for stock market analysts when a stock fluctuates, price-wise, in a narrow band. When a stock is generally trading horizontally, it is more difficult to peg a trading trend on the security, and it's necessary to turn to so-called oscillators, like the Relative Strength Indicator, as a more accurate stock performance indicator.
How to Calculate RSI
As a momentum indicator, the RSI can be a great tool to let investors know when a security should be bought or sold, particularly in ‘overbought’ or ‘oversold’ market scenarios. The calculus for making a "buy" or "sell" determination is as follows:
RSI = 100 - 100/ (1 + RS)
Where,
RS = Relative Strength = Avg Gain / Avg Loss
N = the period of RSI (standard 14-day stock market trading period)
The average gain is equal to the sum of all total gains divided by 14 to obtain the average gain. Consider the following scenario: an investor suffers only five losses over the course of 14 days. In this case, the losses from those five trading sessions are divided by the number of RSI trading sessions. The average loss is calculated in the same way as the maximum loss. The RSI value is computed by dividing the average gain by the average loss over a given period of time. In general, when the price of a stock rises, the relative strength index (RSI) will climb as well. This is due to the fact that average posted gains will outweigh average losses.
Tips to Use it in Stock Market
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Don’t use RSI on an absolute basis: Making any buy or sell decisions based solely on an RSI calculation isn't advisable.
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Know the difference between convergence and divergence: Convergence occurs when the price of an asset moves in the same direction as a related asset in technical analysis. In contrast, divergence means that a trend is weak or potentially unsustainable.