Is Relative Strength Index the Best Indicator for Market?

What Is the Relative Strength Index?

The relative strength index is a momentum indicator used in technical analysis that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock or other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100. The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, "New Concepts in Technical Trading Systems."

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.

The basic formula is:

RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]

How this indicator works

RSI is considered overbought when above 70 and oversold when below 30. These traditional levels can also be adjusted if necessary, to better fit the security. For example, if a security is repeatedly reaching the overbought level of 70 you may want to adjust this level to 80.

During strong trends, the RSI may remain in overbought or oversold for extended periods.

RSI also often forms chart patterns that may not show on the underlying price chart, such as double tops and bottoms and trend lines. Also, look for support or resistance on the RSI.

In an uptrend or bull market, the RSI tends to remain in the 40 to 90 range with the 40-50 zone acting as support. During a downtrend or bear market the RSI tends to stay between the 10 to 60 range with the 50-60 zone acting as resistance. These ranges will vary depending on the RSI settings and the strength of the security’s or market’s underlying trend.

If underlying prices make a new high or low that isn't confirmed by the RSI, this divergence can signal a price reversal. If the RSI makes a lower high and then follows with a downside move below a previous low, a Top Swing Failure has occurred. If the RSI makes a higher low and then follows with an upside move above a previous high, a Bottom Swing Failure has occurred.

Overbought and Oversold Levels

In terms of market analysis and trading signals, when the RSI moves above the horizontal 30 reference level, it is viewed as a bullish indicator.

Conversely, an RSI that dips below the horizontal 70 reference level is viewed as a bearish indicator. Since some assets are more volatile and move quicker than others, the values of 80 and 20 are also frequently-used overbought and oversold levels. 

RSI Ranges

During uptrends, the RSI tends to remain more static than it does during downtrends. This makes sense because the RSI is measuring gains versus losses. In an uptrend, there will be more gains, keeping the RSI at higher levels. In a downtrend, the RSI will tend to stay at lower levels.

During an uptrend, the RSI tends to stay above 30 and should frequently hit 70. During a downtrend, it is rare to see the RSI exceed 70, and the indicator frequently hits 30 or under. These guidelines can help determine trend strength and spot potential reversals. For example, if the RSI isn't able to reach 70 on a number of consecutive price swings during an uptrend, but then drops below 30, the trend has weakened and could be reversing lower. 

The reverse is true for a downtrend. If the downtrend is unable to reach 30 or below and then rallies above 70, that downtrend has weakened and could be reversing to the upside.

What is an RSI Buy Signal?

Some traders will consider it a “buy signal” if a security’s RSI reading moves below 30, based on the idea that the security has been oversold and is therefore poised for a rebound. However, the reliability of this signal will depend in part on the overall context. If the security is caught in a significant downtrend, then it might continue trading at an oversold level for quite some time. Traders in that situation might delay buying until they see other confirmatory signals.

The Difference Between RSI and MACD

The moving average convergence divergence is another trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period exponential moving average from the 12-period EMA. The result of that calculation is the MACD line.

A nine-day EMA of the MACD called the "signal line," is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals. Traders may buy the security when the MACD crosses above its signal line and sell, or short, the security when the MACD crosses below the signal line.

The RSI was designed to indicate whether a security is overbought or oversold in relation to recent price levels. The RSI is calculated using average price gains and losses over a given period of time. The default time period is 14 periods with values bounded from 0 to 100.

The MACD measures the relationship between two EMAs, while the RSI measures price change in relation to recent price highs and lows. These two indicators are often used together to provide analysts with a more complete technical picture of a market.

These indicators both measure the momentum of an asset. However, they measure different factors, so they sometimes give contradictory indications. For example, the RSI may show a reading above 70 for a sustained period of time, indicating the security is overextended to the buy-side.

At the same time, the MACD could indicate that buying momentum is still increasing for security. Either indicator may signal an upcoming trend change by showing divergence from price (price continues higher while the indicator turns lower, or vice versa).

Limitations of the RSI

The RSI compares bullish and bearish price momentum and displays the results in an oscillator that can be placed beneath a price chart. Like most technical indicators, its signals are most reliable when they conform to the long-term trend.

True reversal signals are rare and can be difficult to separate from false alarms. A false positive, for example, would be a bullish crossover followed by a sudden decline in a stock. A false negative would be a situation where there is a bearish crossover, yet the stock accelerated suddenly upward.

Since the indicator displays momentum, it can stay overbought or oversold for a long time when an asset has significant momentum in either direction. Therefore, the RSI is most useful in an oscillating market where the asset price is alternating between bullish and bearish movements.

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Conclusion

The relative strength indicator (RSI) is a popular technical indicator that is used to measure the strength of a security's price action. It compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.

The RSI is calculated using a formula that compares the average gains and losses of a security over a certain period of time. The resulting value is then plotted on a scale of 0 to 100. Generally, an RSI value above 70 is considered overbought, while an RSI value below 30 is considered oversold.

The accuracy of the RSI can vary depending on the stock, market conditions, and how it is used. Some traders use RSI as a standalone indicator to identify overbought and oversold conditions, while others use it in conjunction with other technical indicators or analysis.

It's important to note that like any indicator, RSI is not a crystal ball and should not be used as a standalone indicator. It is best used in conjunction with other technical indicators and fundamental analysis. Additionally, RSI can generate false signals and traders should be aware of the limitations of the indicator and use it accordingly.

It's also worth noting that the effectiveness of the RSI indicator can depend on the time frame and the period used to calculate it. A short-term RSI (calculated over a short period, such as 2 or 3 days) may be more susceptible to false signals compared to a longer-term RSI (calculated over a longer period.