Relative Strength Index (RSI) Definition: Day Trading Terminology
If there is something that counts in binary trading, it has to be the Relative Strength Index. This essential aspect can help you become a successful trader if you understand how to analyze the markets with this significant identifier between overbought and oversold conditions in asset trading.
What is the Relative Strength Index?
This is primarily a momentum indicator, which was developed by a renowned technical analyst Walles Wilder. It works by comparing the magnitude of recent gains and losses over a particular period for analyzing speed and changes in price movements where securities are involved. In the above chart the RSI is the bottom sub-chart that has a blue trend line with overbought and oversold conditions denoted by the red lines.
Calculating RSI is quite easy, but essential to understanding as well.
RSI = 100-100/ (1+RS)
The RS is the Average gain of the periods that recorded high within a given time/ the Average loss of the ones on the downside during such time.
When you are seeking to get the relative evaluation of the strength of a particular recent price performance in securities, RSI comes in handy. This is what makes it a moment indicator, and it ranges from 0 to 100 in value, with 14 as the default time frame that helps in comparison of the up periods and the down periods. The 14 here means 14 trading days.
Usually, the values are analyzed depending on its value. If it clocks Relative Strength Index of 70 and above, this indicates that the security is overbought, also referred to as “overvalued.” This means that the security is bound to a reversal trend, also known as a corrective pullback.
On the contrary, if the Relative Strength Index value drops to 30 or lower, it indicates an oversold condition, usually referred to as undervalued. At this point, the trends headed for an upward reversal, and the sequence keeps going like that.
How to use the Relative Strength Indicator
If there are abrupt bursts of large price movements, there can be false buy or sell signals. It is, therefore, important to use them with refinements when using this indicator. Besides, it can also be used with other confirming technical indicators as well.
To avoid falling to the deception by false relative strength indicator, traders embrace the use of extreme values for signals. These include values above 80 indicating overbought conditions and those below 20 for the oversold indication.
It is usually wise to use RSI along with trend lines, like trend lines for support or resistance tend to coincide with the resistance or support levels for the RSI reading.
Another thing to keep an eye on is the difference between the RSI and prices to refine the indicator’s application. This comes where the security achieves a high or low price range, whereas the RSI is not corresponding accordingly. Bearish divergence happens when the prices move to a new level, but the RSI is stagnant, which is interpreted a sell signal.
A bullish divergence aspect occurs when the prices drop to a new low, but the RSI values do not change. This is construed as a busy signal. There is a lot that comes with RSI in trading. If well observed, this indicator can form the basis for a thriving trade.