Relative Strength Index (RSI): How It Signals Buy/Sell Decision in Stock Trading

Ganesh Adhikari

What is Relative Strength Index (RSI)?

Relative strength index (RSI) is a technical indicator that measures the strength of current price trends in comparison to previous price trends. RSI is one of the best oscillator tools that quickly and efficiently shows the changes in momentum of the market. The RSI tool helps to determine if the asset is overbought or oversold to spot buy and sell opportunities. It was first developed by American technical analyst J. Welles Wilder Jr., in his seminal 1978 book, “New Concepts in Technical Trading Systems,”. This oscillator tool is displayed as a line graph that moves between two extremes (ranging between 0 and 100).

The RSI value of 70 or above suggests that security or stock is moving toward the zone of being overbought and a pullback or a trend reversal is always on the cards. An RSI value of 30 or below shows that the stock is oversold and in undervalued condition. But if you trade (buy or sell) based only on RSI, you are probably more destined to lose money. The RSI predicts only possible price changes. The RSI is effective when combined with moving averages, Bollinger’s Bands, or MACD (moving average convergence divergence).


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RSI Divergence (Ideal Time to Buy and Sell)

An RSI divergence tool spots the loss of momentum in the current market trend and signals possible reversal in trends. The RSI divergence is an earlier indication of a possible break of trend as it doesn’t correlate with the current price action. The RSI divergence indicator signal suggests traders when RSI and the price action of the stock are no longer showing the same momentum.

When the relative strength index (RSI) has lower highs while the price is at a higher high or the RSI makes higher lows while the price makes new lower lows, it shows the RSI divergence in the charts.

Bullish divergence signals for the potential uptrend when the prices fall to a new low but the RSI indicator fails to do so (fall to a new low). This indicates the reversal of the downtrend with the bearish trend losing its grasp in the market. This is a signal for making an entry into the market. A bearish divergence is observed when the prices make a new high while the RSI oscillator refuses to reach a new high. The bearish divergence means the bulls are losing momentum and the bearish trend is about to start. Needless to say, this is a signal to sell off and exit from the market.


RSI During Uptrend and Downtrend

During an uptrend, the RSI tends to stay above 30 and usually hits 70. On the opposite case of a downtrend, RSI rarely exceeds or touches 70 and moves around the range of 30. This can be useful to spot trend strength and potential reversals. If RSI is not able to break above the resistance of 70 several times in the existing trend but falls back to 30, then it signals the weakened uptrend, and the reversal in trend might be forthcoming. Conversely, if the RSI is unable to breach 30 marks in the charts and tests the support level multiple, it is signaled for a possible break of a downtrend and could be reversing to the upside.


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Trading Strategies Using Relative Strength Index Indicator

1. RSI with MACD

Like RSI, MACD is also a momentum indicator that shows the relationship between two moving averages. The buy signal is when the MACD crosses above the signal line and conversely, traders may sell the security when the MACD crosses below the signal line. When RSI is in overvalued or oversold territory (traditionally above 70) and the MACD crosses below the signal line, it is confirmation for the sell signal. In the same way, When RSI is in the undervalued or undersold territory (traditionally below 30) and the MACD crosses above the signal line, it is confirmation for a buy signal.


2. RSI with Moving Averages (MA)

Moving average crossovers are very effective to confirm RSI indications for market situations of overbought or oversold or possible market reversal trends. The moving averages such as exponential moving averages (EMAs ) which respond quickly to recent price changes can complement RSI signals to make better trades.

For example, 5 days moving exponential moving average (EMA) crossing over 20 days EMA can complement RSI indications. If the 5 days EMA crosses below 20 days EMA when RSI is indicating overbought condition, it is a confirmation for a sell signal, even chance of possible trend reversal. Conversely, traders may buy the securities when 5 days EMA crosses above 20 days EMA with RSI signaling undersold. Higher trading volume at the time of crossover further strengthens the trading signal.


3. RSI with Bollinger’s Band

Bollinger Bands are one of the most common technical indicators which plot three separate lines in the price charts. Bollinger Bands plot the lines at a standard deviation level above and below a simple moving average of the price. When RSI is combined with Bollinger Bands, traders can spot the buy and sell positions in the chart.

When the RSI is above 70 and the stock price reaches the upper band of a Bollinger Band price channel, the trader may sell the securities or stocks as it interprets the stock is overvalued. Conversely, When the RSI is below or around 30 and the stock price reaches the lower band of a Bollinger Band price channel, the trader may place buy the securities or stocks as it interprets the stock is undervalued or under bought.


Best Suited Indicator for

Although the RSI indicator can be useful for most of the trading strategies it is most suited for swing trading and pullback trading strategy. In swing trading, the traders try to take advantage of the short-term trend change. The RSI helps to spot reversal patterns early making it the right tool for such traders. Similarly, in pullback trading, the RSI indicator can be used to make the right entry point in an established trend when the market has pulled back.


Conclusion

The RSI indicator is one of the most effective and confirmation tools that could boost your technical analysis arsenal. It should be always remembered that the RSI tool is not to be implemented alone but only be used to confirm the trend for other technical indicators such as moving averages and Bollinger Bands. The RSI indicator is a powerful tool for every trend and trader.


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