Relative Strength Index Explained: A Complete Guide To Its Operation

As the trading market continues to expand, your knowledge about its operation and basic components should too.

And if you’re really looking to profit and invest long-term, you need to know more than just how much you’re willing to offer.

One of the most crucial components of finance is its RSI or Relative Strength Index. And if you know this by heart, you can pretty much rest assured you’re on a good path.

So, what is RSI trading? And just how essential is RSI trading to your profit and shares? Keep reading, and we’ll tell you all about it.

What Is an RSI (Relative Strength Index)?

The Relative Strength Index, or RSI, is an oscillator index developed by J. Welles Wilder in the year 1978.

It is a technical indicator that is used to analyze financial markets. This tool charts a market’s current and historical strengths and weaknesses based on its recent trading period’s closing prices.

In simple terms, a relative strength index indicates whether a certain security or currency is oversold or overbought. This allows investors to identify if buying or selling shares will profit them in the current period.

So how does the relative strength index work?

RSIs oscillate momentum; of course, in finance, the momentum is the rate of rise and fall in value. So it basically measures both the velocity and magnitude of the price fluctuations in the market.

Doing so allows it to identify whether a stock has had more positive changes or higher RSI or more negative changes or lower RSI.

How Does RSI Trading Indicator Works?

The relative strength index system is used within a 14-day timeframe. Shorter or longer timeframes may also be used when the motive is to identify shorter or longer outlooks.

The indications happen within its 0-100 scale, where 30 is marked as a low level, and the high level is 70. Any level within these barely occur, but when they do, it is commonly an indication of stronger momentum.

These low and high levels directly translate into the market’s current state. So high levels of 70 and above are known as overbought zones where it’s best to sell. On the other hand, low levels of 30 and below are called oversold zones, where it’s best to buy.

These indications are, of course, not automatic. Some formulated calculations and plotting is necessary to identify these levels and guarantee their accuracy.

But this is not the only purpose of the RSI trading indicator. Its signals may also be used when searching for divergences and failure swings or even simply just identifying the general trend.

Although RSI produces promising results when tested, it can still be overcome with buy-and-hold strategies. So it’s not really painstakingly accurate at all times but is still helpful for low-trend periods.

Calculating RSI With A Free Timeframe: A Two-Step Formula

In calculating the relative strength index, the first formula is:

  • RSI value = 100 – [100 / (1 + Average Gain / Average Loss)]

Followed by:

  • RSI value = 100 – [100/ 1+ (Previous Average Gain) + Current Gain / ((Previous Average Loss) + Current Loss)]

The result of these computations will later be plotted for a final RSI value.

The default setting for RSI is 14 in correlation to its 14-day timeframe. But, again, this value may increase or decrease depending on your requirement.

Doing so will surely impact the results. For example, having a shorter time frame will more likely reach overbought or oversold levels in comparison to a longer time frame.

Plotting RSI Through A Spreadsheet: The Simplified Version

After calculating the RSI, you are left with the results to plot, and here’s how you can do it.

First, you’ll have to choose a spreadsheet, whether that’s Microsoft Excel or google sheets. On it, you’ll be inputting the first-day data and quite a lot of formulas.

Now, the whole plotting procedure may be tough and tedious, but once it’s fully formatted and formulated, it will run smoothly and independently.

When the plotting is all set, all you have to do is update the daily market closing values on their appropriate dates. Once accomplished, you’ll have your RSI values.

Why Is RSI Important?: Its Five Functions

RSI trading strategy plays a huge and important role in predicting the market’s statistics.

One of the common uses of the RSI trading system is the trendline application. By applying closing trend lines in the same manner in RSI, you’ll receive advanced buy or sell signals.

And when it comes to pattern breakout, RSI will consider the underlying relative strength of a stock over a specific period of time. This means that you’ll be a couple of days ahead of the market price breakouts.

In accordance with this, RSI also works as an advanced breakout and breakdown indicator. This is basically an early signal indicating that the price will breach the previous top.

RSI also has the ability to indicate price direction using the mid-50 line, more known as the Role of 50.

And lastly, the failure swing or the indication of the movement of oversold and overbought levels.

RSI trading Limitations: The Failure Line

Now, no matter how useful RSI may be, it is still bound to its limitations.

An RSI trading example of limitations would be how its accuracy drops lower as the trend grows stronger. This leads to misleading overbought and oversold signals, which will lead you to buy/sell in periods that you shouldn’t.

This happens when RSI remains in overvalued and devalued zones longer than it should, thus leading it to indicate the wrong signals. Meaning to say it moves without featuring a clear trend for an extensive period.

The best way to counter this is to avoid buying in oversold zones and vice versa (selling) whenever the trend is strong.

To sum it up, you should only selectively rely on RSI trading meaning only act based on its indications when the trends are weak. And when the trends grow stronger, make sure to study and re-evaluate its indications comprehensively.


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