Remember, an uncalculated or unplanned trade can result in a huge loss. Therefore, most traders use several indicators paired with some risk management tools to determine the market’s trend. And one of the best options for determining the market’s trend is the relative strength index (RSI).
Stocks RSI is one of the few indicators that can help you make an informed decision when taking positions. So if you want to know what does RSI mean stocks, please read on.
What is the RSI (Relative Strength Index)?
The stocks RSI is a unique momentum indicator that’s used in technical analysis. This indicator charts a market’s historical and current weakness or strength as per the closing price of a certain trade period. Therefore, you should not mistake stocks RSI for relative strength.
This indicator is ideal for measuring the magnitude and speed of a security’s recent price change. It does this by evaluating the undervalued or overvalued condition of the security’s price. The magnitude refers to the rate at which the price rises and falls.
Generally, it’s a line graph or an oscillator on a scale ranging between zero and 100. Welles Wilder Jr. developed the RSI and introduced it in his 1978 book, “New Concepts in Technical Trading Systems.”
In fact, it can do more than help you find an oversold or overbought security. It also can indicate securities that are primed for a corrective pullback or trend reversal in price. This indicator can tell you when to sell or buy.
How Does RSI Trading Indicator Works?
Generally, a reading of below 30 shows an oversold situation, and over 70 indicates an overbought condition. Fortunately, you can adjust these levels to fit a certain security. For instance, if a stock reaches an overbought level of 70 several times, then you should adjust it to 80.
After all, when the trends are strong, the relative strength index will remain in an oversold or overbought state for an extended period. It always forms a chart pattern that’s not always shown on the price chart, like the trend lines, so you should consider the resistance and support on the RSI.
In a bear market, the stocks RSI will remain between the 10 and 60 range, with 50 to 60 being the resistance. On the other hand, in a bull market, it would range between 40 and 90, with the support being at the 40-50 zones. These ranges vary with the market’s trend, the security’s strength, and RSI settings.
When the price makes a new low or high that’s not confirmed by the relative strength index, then the divergence will signal a reversal. If this indicator makes a high low followed by an upward move exceeding the previous high, then a bottom-swing failure has occurred.
Top swing failure can also occur.
Calculating Stocks RSI
Now that you already know the answer to “what is RSI in stocks?” you need to know how to calculate RSI.
RSI =100-(1000/ [1+RS])
Before determining the RSI, you must calculate RS (relative strength).
RS=Umean / Dmean.
In this case,
Dmean refers to the mean of the stock’s downward price movement for the last N-bars. N is equal to the duration of the relative strength index. Umean is the opposite of Dmean. It refers to the mean of upward price movement for the last N bars.
When calculating the RSI, you should do the following:
- Start by collecting data about a company over a period of 15 days, and make sure you compute the daily percentage change in price.
- Compute a 14-day average by calculating the Dmean and Umean for 14 days.
- Determining the RS by dividing the 14 days average gain by the average loss.
- Finally, you can calculate the RSI using the above formula.
After calculating the RSI, you can plot the RSI indicator below the asset’s price chart. The RSI will drop as the size and number of down days increase. On the other hand, it will rise as the size and number of up days increase.
When well plotted, the RIS can stay oversold for an extended period when in a downtrend. It can also remain in an overbought region for a very long time when in an uptrend. This may seem confusing for a beginner, but learning how to use it in a prevailing trend can help clarify these problems.
Why is RSI Important?
RSI is one of the most crucial tools that can help you determine the trend of certain stocks. If there is a possible uptrend, then the RSI stock indicator should be above 50. On the other hand, if it’s a downtrend, then it will be below 50.
Using this information, you can easily validate trend reversals and even validate trends. It can also help you predict the behavior of the security.
RSI can help you determine when the stock is oversold or overbought. When the RSI is above the 70 mark, it is a bearish sign. If it’s less than 30, then it’s a bullish sign. But when it crosses 70, then it’s considered overvalued or overbought, and vice versa.
Therefore, it’s the best tool for providing short-team investors with sell-and-buy signals. So you should use it together with other technical indicators to support your trading strategies.
Stocks RSI Limitations
Now that we have learned more on RSI stock meaning, we need to understand that it does have limitations. This indicator compares the bearish and bullish price momentum and displays the outcome below the price chart. And like most indicators, the stock RSI is reliable when conformed to a long-term trend.
On the other hand, a true reversal signal can be quite rare and almost impossible to separate from a false alarm. For instance, a false negative will be a bearish crossover followed by an accelerated upward movement. A false positive can also occur.
But since it displays momentum, it can remain oversold or overbought for an extended period when it has significant momentum. So it can be useful when the price is alternating between bearish and bullish movements in an oscillating market.