The Relative Strength Index (RSI) is a popular momentum oscillator, mainly used in tracking technical charts of commodities (much like other technical indicators, such as Japanese Candlesticks). It seems to work pretty well with stocks also.
Developed by J Welles Wilder in 1978, the RSI calculates the velocity (i.e. speed) and momentum (i.e. the rate of rise or fall) of closing prices/index levels in upward and downward directions. In simpler words, the RSI compares the magnitude of the recent gains and losses of a stock or index, and converts it into a numerical range.
The Relative Strength Index (RSI) does not measure the relative movements between two different stocks or indices. Rather, it measures the internal strength of a stock or index in the up or down direction. So it is a bit of a misnomer.
Being an oscillator, its value oscillates (varies) between 0 and 100. A value of 70 or higher is considered 'overbought' and a value of 30 or lower is considered 'oversold'. Some analysts use 80-20 as the overbought-oversold values.
The oscillator tends to form chart patterns like head-and-shoulders and triangles - some times much before similar patterns form in the stock or index charts.
Whenever the RSI enters the overbought or oversold regions, a trend reversal is likely to follow. Another important indication provided by the RSI is divergence from the pattern of a stock or index.
Enough theory. Now on to some practical examples by looking at the 6 months closing price of the BSE Sensex chart pattern along with a 14 day RSI:-
First, a look at the oversold and overbought regions. In early Mar '09, the RSI entered the oversold region (below 30) as the Sensex was making a low. A reversal of the previous down move followed. In late Mar '09, the RSI entered the overbought region (above 70) but remained at or near this region till the middle of Jun '09 while the Sensex rallied.
This is an indication of the imperfect nature of technical analysis. The reversal from oversold region was swift. But a reversal from overbought region took much longer. This is the reason for using several different technical indicators before coming to a conclusion about buying or selling.
Now let us look at three different divergences between the BSE Sensex chart pattern and the Relative Strength Index. During mid-Dec '08 and early Jan '09, the Sensex made a slightly higher top. The RSI made a slightly lower one. This negative divergence caused a short reaction.
From early Jan '09 to the middle of Feb '09, the Sensex made a lower top but the RSI made a higher one. The positive divergence. along with the RSI entering the oversold region led to the huge rally.
The rally continued, and from mid-may '09 to mid-June '09, the Sensex made higher tops, but the RSI failed to make higher tops. The inevitable correction is the result of this negative divergence.
It is a lot easier to sit back and analyse after the event. A lot tougher to place buy/sell bets as these patterns occur in live markets. No wonder it is so difficult to make money by day trading!
It also reinforces my view that for ordinary small investors, neither technical analysis alone, nor fundamental analysis alone can work well over long periods of time.
A combination helps you to identify good stocks through fundamental analysis, and then use technical indicators like the Relative Strength Index (RSI) and slow stochastic to time your entry and exit.
I have deliberately not marked another instance of divergence on the above chart. Observant readers should be able to find it! The reward for correct identification will be a special mention in my blog.