Relative Strength Index (RSI)
Market Live brings in the Stock Market Tutorial which explains the basics of Technical Analysis of the Stocks. Technical Indicator – Relative Strength Index – (RSI) is explained in a simple manner here.
RSI is a popular technical indicator that was developed by Welles Wilder. It is very popular because its very simple to interpret this indicator. It is an oscillator indicating the overbought and oversold conditions of the stock.
RSI is based on the comparison of the magnitude of the gain to the loss. It is the ratio of the EMA of Upward(U) and Downward(D) movements, which is then normalized to values between 0 to 100.
Pc represents the current Closing price
Pp represents the previous Closing price,
then on a day when the stock has closed up, U = Pc – Pp and D = 0
Similarly on a day when the stock has closed down, D = Pp – Pc and U = 0
Then EMA is calculated for U and D for a period n , represented respectively by EMAup and EMAdn.
Now RSI is calculated as follows:
RSI = 100 x (EMAup / (EMAup + EMAdn) )
Generally a 14 period RSI is plotted for the close prices of the stock. RSI Value of 70 and above is considered to indicate that the stock is in Over Bought condition. Similarly an RSI value of 30 and below is considered to indicate that the stock is in Over Sold condition.
The Over Bought condition indicates that the stock price may be getting over valued and in the next trend may be a candidate for pullback in the downward direction. Similarly the over sold condition indicates that the stock may be getting under valued and in the next trend may be a potential candidate for a pullback rally in the upward direction.
Example : Consider this chart of the Infosys Technologies stock in the NSE:
The yello line at the top indicates the Close price of the stock over a period of time. The bottom line in torquoise blue indicates the 14 day RSI for the Close price of the stock.
As you can see in the chart, when the RSI values have crossed the 70 value, the stock enters the Overbought zone and becomes a candidate for pulldown thus giving a sell signal. Thus a downtrend in the price of the stock is seen after this condition.
Similarly when the RSI values have come below 30, the stock enters the Oversold zone and becomes a candidate for pullback thus giving a buy signal. Thus an uptrend in the price of the stock is seen after this condition.
However large surge and drops in the price of the stock will affect the RSI heavily and can lead to erratic buy and sell signals. So RSI should always be used in conjunction to other technical indicators to confirm the buy and sell signals.