What is the Relative Strength Index?

The Indian stock market has come a long way from an open outcry system where investors had to visit the stock exchange with physical share certificates to make a trade. Today, you just have to log in to your demat account to see every financial information available about a particular stock. The charts, graphs, financials, etc., are were lacking when there were no technologically backed trading platforms. With such detailed information, today’s investors are better positioned to make profits than before as the details can be used to predict the market trend, evaluate a stock, and make informed investment decisions.

However, evaluating a stocksis not as easy as it sounds. As the stock market is volatile, it is never consistent with a particular trend. The price movement can go negative or positive in a matter of hours, forcing an investor to incur losses. Then, how do experienced investors make sure they are investing in the right stock, and it will go higher in price even after it falls?

The investors owe their success to technical indicators such as the Relative Strength Index (RSI) which they use to execute Trend Trading.

What is Trend Trading?

A Trend is the direction of the market; it can be bearish(falling prices) or bullish (rising prices). Past market patterns reveal that asset prices follow a trend where if the market is bullish, the prices keep on rising in the future.

Thus, investors looking to profit place an order in such conditions hoping that the market will follow the current trend. Trend Trading is the trading style through which investors attempt to realize profits based on the current market trend and the asset’s momentum. Trend Trading is undertaken by investors based on various technical indicators to help them identify the current market trend.

What are Technical Indicators?

Technical indicators are mathematical computations plotted as lines on a price chart that aid traders in identifying certain signs and trends in the stock market. They are simply a set of tools applied to a trading chart to demystify the market and make a clearer analysis. There are numerous technical indicators used by investors such as Moving Averages<, One balance volume, etc. One of the most widely used technical indicators is the Relative Strength Index.

What is the Relative Strength Index?

When it comes to overbought and oversold stocks, the big question is not ‘if’ but ‘when’. The timing of your entry and exit is what matters as it can allow you to either realize profits or losses. The Relative Strength Index answers the question of ideal entry and exit points for investors.

The Relative Strength Index (RSI) is another oscillating indicator that traders use to assess market momentum, market conditions, and warning signs for potentially hazardous price changes. Its value spans from 0 to 100. An oscillator helps the trader to identify whether the particular stock or contract is overbought or oversold. Generally, an asset reaching the 70 levels is considered to be overbought, whereas an asset around the 30 levels is considered to be oversold by the market.

The Formula for RSI

The Relative Strength Index tends to remain in the 40 to 90 range during an uptrend market, making the 40-50 levels the support level. On the other hand, the Relative Strength Index tends to stay between the 10-60 range during a downtrend, making the 50-60 level the support level.

For an investor looking to find the Relative Strength Index of a stock, the formula for calculating the Relative Strength Index is listed below:

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

Difference between the Relative Strength and Relative Strength Index

A major mistake some investors commit is to confuse the Relative Strength Index with Relative Strength. Although both the names sound the same, they are entirely different in their definitions and calculation.

The Relative Strength Index is an oscillator that is used in Trend Trading and provides information about a stock being overbought and oversold. However, Relative Strength is a stock market technique used by investors to evaluate a stock compared to another stock, benchmark, or index. The Relative Strength is presented in a ratio, while the Relative Strength Index is a point between 0-100.

They both have entirely different formulas. As you already know how the Relative Strength Index is calculated. Here is the formula for calculating the relative strength.

Relative Strength: Stock (1) Trend Price/ Stock or benchmark or index Trend Price

A ratio of 1 depicts that the stock is performing similar to the performance of the compared security, index, or benchmark. If the ratio is greater than 1, it would mean that the stock is outperforming the compared security, index, or benchmark and can allow you to earn better returns.

Final Words

Technical Indicators such as the Relative Strength Index make up a crucial part of Trend Trading and allow investors to understand if the stock is overbought or oversold. An overbought signal may push for a market correction, indicating that it is a good time to exit the market, while an oversold stock would mean that it can rally in the future. As per the Relative Strength Index level, investors can know when to enter or exit their positions and make profits.