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Fundamental Analysis

What is the Relative Strength Index? How to use it?

The Relative Strength Index (RSI) is a momentum indicator that measures the velocity and magnitude of stock price changes.

Developed by Jone Welles Wilder Jr., the RSI uses the values of stock price gains or losses over a certain period. It calculates a number between 0 and 100 based on a specific formula.

Generally, an RSI over 70 indicates that a stock is overbought (its price is considered too high), while an RSI below 30 suggests the stock is oversold (its price is deemed too low).

The 30/70 threshold can sometimes be adjusted based on stock price trends, such as changing it to 20/80.

image
Source: IBRK Web Version

In most cases, the RSI trend aligns with the stock price movement. However, divergences can occur, requiring investors to have sufficient experience to interpret these trends and their implications for price fluctuations.

It’s important to note that the RSI calculation is based solely on stock price gains and losses over a specific period. Therefore, when assessing a stock for buying or selling, it’s crucial to consider a broader range of financial indicators for a comprehensive evaluation.

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This article uses Apple Inc. stock (AAPL) as an example. This stock is used solely for demonstration purposes and is not intended as a purchase recommendation. Remember: Investing in the stock market involves risks, and investments should be made with caution.

How to Calculate the Relative Strength Index?

The calculation for the Relative Strength Index (RSI) is as follows:

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

in which,

  • The typical period for calculating the average is 14 days.
  • The average of downward price changes is taken as a positive number. For example, if the average price drop is $1.5, it is considered 1.5, not -1.5.
  • To calculate the average upward price changes, the values on days when the stock price falls are treated as zero. This means adding up all the increases in stock price and dividing by 14. Similarly, when calculating the average downward price changes, the values on days when the stock price rises are considered zero. This involves adding up all the decreases in stock price and dividing by 14.

How to Calculate the Relative Strength Index for Apple Inc.?

This section demonstrates how to calculate the current RSI value using historical stock prices obtained from Apple Inc.’s investment website.

图片 8

To calculate the daily change in stock price, we subtract the previous day’s closing price from the current day’s closing price.

DateClosing Price
($)
Gain
($)
Lose
($)

5/2/2022

157.96

5/3/2022

159.48

1.52

5/4/2022

166.03

6.55

5/5/2022

156.77

9.26

5/6/2022

157.28

0.51

5/9/2022

152.06

5.22

5/10/2022

154.51

2.45

5/11/2022

146.50

8.01

5/12/2022

142.56

3.94

5/13/2022

147.11

4.55

5/16/2022

145.54

1.57

5/17/2022

149.24

3.7

5/18/2022

140.82

8.42

5/19/2022

137.35

3.47

5/20/2022

137.59

0.24

合计

19.52

39.89

From the table,

  • The average of stock price increases is: $19.52 / 14 = $1.394
  • The average of stock price decreases is: $39.89 / 14 = $2.849

Therefore,

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

= 100 – 100 / (1 + $1.394 / $9.973) = 12.26

This calculation indicates that the current stock price of Apple is in an oversold state (<30).

What is the significance of Using the Relative Strength Index?

The Relative Strength Index (RSI) is a popular technical analysis tool used to assess overbought or oversold conditions in stocks or other financial assets.

Here are some common scenarios for using RSI to gauge market trends:

1. Overbought or Oversold

When the RSI is above 70, the stock is considered overbought. This means that there are more buyers than sellers, indicating a strong upward trend.

When the RSI is below 30, the stock is considered oversold. This suggests that there are more sellers than buyers, and the price is near the bottom and might rebound. It’s also seen as undervalued, presenting a potential opportunity for investors to buy low and sell high.

The 30/70 threshold can be adjusted based on the actual stock price movement. For instance, if a stock’s RSI frequently hovers around 70, the threshold might be adjusted to 80 for a better assessment of the trend. Similarly, the lower threshold can be adjusted to 20.

2. Divergence

RSI Divergence occurs when there is an inconsistency between the stock price trend and the RSI trend. This divergence is often viewed as a potential signal for a trend reversal.

Divergence is of two types: Bearish Divergence and Bullish Divergence.

Bearish Divergence happens when the stock price hits a new high while the RSI does not. Although the price is rising, the weakening momentum might indicate a potential downward trend in the stock price.

Relative Strength Index Bearish Divergence
Bearish Divergence (Image from IBKR)

Bullish Divergence occurs when the stock price reaches a new low, but the RSI does not hit a new low. This indicates that although the price is declining, the downward momentum is weakening, potentially signaling an upcoming uptrend in the stock price.

Relative Strength Index Bullish Divergence
Bullish Divergence (Image from IBKR)

3. Failure Swing

Failure Swings in the Relative Strength Index (RSI) are a specific pattern within the RSI indicator, used to predict potential reversals in market trends. This pattern is independent of price action and is based solely on changes in RSI values.

Failure Swings are categorized into two types: Failure Swing Top and Failure Swing Bottom.

Failure Swing Top: This occurs when the RSI first exceeds 70 (entering the overbought zone), then falls back, rises again but fails to exceed the previous high, and subsequently falls below the low point between these two highs. This formation is seen as a sell signal, indicating a potential downward trend. Visually on the RSI chart, this pattern resembles the letter “M”.

Failure Swing Top Relative Strengh
Failure Swing Top (Image from IBKR)

Failure Swing Bottom: This occurs when the RSI first falls below 30 (entering the oversold zone), then rebounds, drops again but does not fall below the previous low, and subsequently rises above the high point between these two lows. This formation is considered a buy signal, suggesting a potential upward trend. The pattern of the RSI on the chart resembles the letter “W”.

Failure Swing Bottom of Relative Strength
Failure Swing Bottom (Image from IBKR)

These two types of Failure Swings provide potential trading signals, but they should be approached with caution. It’s best to use them in conjunction with other technical analysis tools to enhance the accuracy of trading decisions.

What are the limitations of using the Relative Strength Index?

The RSI is a widely used technical analysis tool, but it has certain limitations.

The RSI is typically more suited for short-term investors. Long-term investors, who focus on fundamental analysis, need to consider more comprehensive aspects of a company’s fundamentals like profitability and overall business capabilities.

The limitations of RSI are summarized as follows:

  • Misleading Overbought/Oversold Zones: The overbought (usually above 70) and oversold (usually below 30) zones of the RSI are not always accurate indicators for buying or selling. In a strong trend market, the RSI can remain in these zones for an extended period without necessarily indicating an imminent reversal.
  • Ineffectiveness in Trend Markets: In sustained bull or bear markets, the RSI can produce misleading signals. For example, in a strong upward trend, the RSI may continuously indicate an overbought condition, misleading investors into thinking that a market correction is imminent.
  • Delay in Price Divergence Signals: While RSI divergence can be a powerful signal for market reversals, it often comes with a delay. By the time a divergence is confirmed, the market may have already reversed for some time.
  • Necessity to Use with Other Tools: The RSI works best when combined with other technical analysis tools and indicators to enhance the validity of signals. Using RSI alone may not provide sufficient trading signals.
  • Subjectivity in Parameter Selection: The calculation of the RSI depends on the chosen period (such as 14 days, 10 days, etc.). Different choices of parameters can lead to varying results, adding subjectivity to the analysis.

How to Use Relative Strength Index in IBRK?

盈透 (Interactive Brokers) is an international brokerage firm offering a wide range of trading and investment services, suitable for individual, professional investors, and institutional clients.

For a detailed introduction to Interactive Brokers, please refer to the article “Interactive Brokers Deposit and Investment Guide.”

Next, let’s see how to use the Relative Strength Index in the IBKR web platform

Go to the Interactive Brokers homepage and log in to your account.

Find the stock you are interested in, using AAPL (Apple Inc.) as an example.

In the stock’s candlestick chart, locate the menu item “Indicators.”

IBRK中找到Indicators

In the “Indicators” pop-up menu, type in “RSI”. From the search results, select “Relative Strength Index.”

how to find RSI from indicators

Then the Relative Strength Index will be displayed below the candlestick chart.

IBKR中查看相对强弱指标

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