Relative Strength Index Masterclass Part 1Relative Strenght Index(RSI)
RSI is a momentum oscillator, whereas the momentum is the rate of the rise or fall in price.
RSI is an oscillator ranging between two extremes, in the case of RSI, it ranges from 0 to 100.
The relative strength index is computed with: RSI = 100RS/(1+RS); where RS is relative strength.
RS= (Previous Average gain*13+Current gain)/(Previous Average loss*13+Current loss)
Relative Strength is a ratio of a stock price performance to a market average (index) performance.
RSI will rise as the number and size of positive close increases and will fall as the number and size of losses increase.
There are two terminologies for RSI:
Lookback period: The time frame that is used to calculate the relative strength, by default it is 14. A look-back period greater than 14 will give a smoother RSI signal while less than 14 will give a rough volatile RSI signal
Threshold Frequency: The oversold-overbought value ranges are the threshold frequency, default is 70-30 (which depend on various factors reasons such as risk factor), for eg. 80-20(less risk) and 66-33 (more risk)
RSI touching the overbought condition is a bearish sign (prices are likely to go down) while RSI attaining oversold condition is a bullish sign (prices are likely to increase)
There are many ways of using RSI as an indicator
Oversold-Overbought Region :
Oversold Region - The situation at which a lot of selling has happened and everyone who was willing to sell has sold, RSI value less than 30
Overbought Region - The situation at which a lot of buying has happened and everyone who was willing to buy has bought, RSI value greater than 70
In this, we have default values for the lookback period(14) and threshold frequency(70-30) which you can change according to your requirement and risk management.
A look-back period of more than 14 would be more interested in long term trend while less than 14 would be inclined towards short term trades. The look-back period can also be increased to smoothen out the RSI line.
A threshold of 80-20 (more-safer) or 66-33 (more-riskier) can be taken into consideration.
A Buy signal will be generated when RSI is less than 30 i.e. the oversold region while a Sell signal will be generated when RSI is greater than 70 i.e. overbought region.
50-Level RSI Midline
The overbought-oversold condition helps detect sudden changes in the momentum of price without providing much information about the overall trend of the market, therefore using the overbought-oversold strategy without getting information on the overall trend could be a bit risky.
Thus we use RSI with different timeframes and the threshold for trend information as well as signal generation.
In this we will have two different RSI:
A RSI with the look-back period of 20-days and 50-50 frequency, also called midline RSI. In an uptrend, this RSI is above 50 and below 50 for a downtrend.
A RSI with the look-back period of 5-days and 66-33 frequency, the look-back period is sufficiently low so that in a predominant trend, local maxima or minima can be used for generating buy or sell signal with the small look-back period RSI ensuring the signal is reactive to current price fluctuations.
Thereby, an uptrend is signaled if 20-RSI is greater than 50, with the buy signal being generated in the uptrend with 5-RSI in the oversold region while a downtrend is signaled if 20-RSI is less than 50, with the sell signal being generated in the downtrend with 5-RSI in the overbought region.
A buy signal is generated when 20-RSI is greater than 50 and 5-RSI is less than 33 while a sell signal is generated when 20-RSI is less than 50 and 5-RSI is greater than 66.
A lot more interesting things can be done using RSI, about which we'll be talking in the next Masterclass on RSI, STAY TUNED!
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- Mudrex
