Understanding RSI
The Relative Strength Index (RSI) acts as an indicator used to measure the volume of trading activity in the market. It is often referred to as a Momentum Oscillator because it measures the direction and size of price movements, and computes momentum as the ratio of the highest or lowest closing prices.
The RSI was first introduced by J. Welles Wilder in 1978 through his book "New Concepts in Technical Trading Systems" and also via the Commodities magazine, later renamed Futures. Today, it is one of the most common tools used by traders.
The standard calculation for RSI utilizes a 14-period timeframe, generating a percentage score ranging between 0 and 100. Specific points within this range indicate overbought or oversold situations, which means there's excessive buying or selling. The designated levels are:
0-30: Oversold zone
30-70: Neutral trading zone
70-100: Overbought zone
Primary Techniques to Interpret RSI Values
If the RSI score exceeds 70, it suggests an overbought situation, indicating a potential price drop. However, reaching an RSI of 70 doesn't certainly call for a sell order—it's merely one factor in your overall decision-making approach.
If the RSI falls below 30, it indicates an oversold situation. This may hint at a possible return of buying pressure, potentially causing the price to rise. Traders can incorporate this insight into their forward-looking strategies.
Calculation of RSI
The calculation process for the Relative Strength Index (RSI) may look complicated, but it's optional to perform it manually. Nonetheless, comprehending the underlying principles of the calculation could prove advantageous.
In the formula shown above, we begin with 100 minus the ratio of the average gain and the average loss, converted into a percentage. The average gain and loss are related to the positive and negative movements. If the calculation uses 14 periods (RSI 14), it implies that we aggregate the gains over these 14 periods and divide them by the number of upward movements. The process for calculating the average loss is similar. The Relative Strength (RS) is obtained by dividing the average gain by the average loss. Once we've calculated the RS value, we adjust it by multiplying the previous average gain by 13, adding the current gain, and then dividing by 14. The same calculation is done for the average loss, leading to the final RSI value.
Defining RSI Divergence
RSI Divergence acts as a reversal indicator, emphasizing when a price trend is inconsistent with the RSI. It enables traders to identify more accurate price reversal instances than by relying on RSI. Two main types of divergence are known: Bullish Divergence and Bearish Divergence.
The role of RSI values is critical because they can reveal extreme buying or selling pressure, potentially leading to sudden shifts in the price chart. These predictive signals can assist us in making better-informed choices when placing buy or sell orders. However, it's not recommended to rely on RSI values solely; it's important to validate these with other supportive data to minimize investment risks.
Conclusion
The use of RSI proves advantageous in monitoring market trading volumes and identifying price patterns. Yet, depending entirely on RSI can result in risks and portfolio losses. It's advisable to use RSI in pair with other tools. Traders who are less experienced should diligently examine how the RSI of each selected asset varies. In particular, grasping the Overbought and Oversold conditions is essential since traders can't predict the final position of the price.
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Updated
1 year ago
(Jun 20, 2023 16:29)
