January 19


How to use RSI indicator to take decisions on buying and selling stocks

The relative strength index (RSI), one of the most popular technical indicators, is computed on the basis of the speed and direction of a stock’s price movement. This means that the RSI indicator only measures the stock’s internal strength (based on its past) and should not be confused with its relative strength, that is compared with other stocks, market indices, sectoral indices, etc.

Computation: The RSI is calculated using a two-step process. First, the average gains and losses are identified for a specified time period. For instance, if you want to calculate the 14-day RSI— you can consider any time period, but the 14-day RSI is the most commonly used—suppose the stock went up on nine days and fell on five days. The absolute gains (stock’s closing price on a given day — closing price on the previous day) on each of these nine days are added up and divided by 14 to get the average gains. Similarly, the absolute losses on each of the five days are added up and divided by 14 to get the average losses. The ratio between these values (average gains / average losses) is known as relative strength (RS). To make sure that the RSI always moves between 0 and 100, the indicator is normalised later by using the formula given below:

RSI = 100 – 100 / (1+RS*) * RS = Average gains / Average losses


Overbought/oversold levels: The RSI value will always move between 0 and 100; the value will be 0 if the stock falls on all 14 days, and 100, if the price moves up on all the days). This implies that the RSI can also be used to identify the overbought/oversold levels in a counter. As suggested by J Welles Wilder, the developer of this indicator, most technical analysts consider the RSI value above 70 as ‘overbought zone’ and below 30 as ‘oversold zone’.

However, investors and traders need to adjust these levels according to the inherent volatility of the scrip. For instance, volatile stocks like Reliance Power may hit the overbought and oversold levels more frequently than stable stocks like Hindustan Unilever, if the 70 and 30 levels are maintained.

Failure swings: The main problem faced by the short-term traders who use indicators is that the stock may continue to move up despite the indicator hitting the overbought zone, or continue to go down even after the indicator hits the oversold zone. This is the reason Wilder developed a new concept called ‘failure swing’ for the RSI. A ‘bearish failure swing’ occurs when the RSI enters the overbought zone (goes above the 70 level) and comes below 70 again. In other words, a short position can be taken only when the RSI cuts the 70 lines from the top. Similarly, a ‘bullish failure swing’ occurs when the RSI enters the oversold zone and comes out. Both the positive and negative failure swings can be clearly seen in the chart on Reliance.

Wilder also explains the possibility of a failure swing above 70. In this case, the RSI needs to make a lower bottom above 70. As an example, consider the RSI hits 76 and then pulls back to 72, before jumping again to 78. In this case, the ‘failure swing above 70’ occurs when the RSI goes below 72. So, there is no need for the traders to wait for the RSI to fall below 70. Similarly, a failure swing can take place if the RSI makes a higher top below the 30 level.


Divergence: This rule is similar to the divergence rule for other indicators as explained in the earlier issues. A positive divergence occurs when the RSI makes a higher bottom despite lower trending by share price. Similarly, a negative divergence occurs when the RSI starts falling and makes a lower top despite the share price moving higher. This can be seen in the chart on Bharti Airtel.

Trend direction: ‘Trend is your friend’ is a cardinal rule of technical analysis and the investors/traders can benefit by trading in the direction of the trend. The RSI is also used for determining and confirming the trend.

For example, it rarely falls below 40 in the case of a stock that is in a strong uptrend, and usually moves between 40 and 80 levels. This type of situation can be seen in the HCL Tech chart. In such a case, when the RSI approaches 40, it can be used as a buy signal, and when it comes close to 80, it can be a square-off signal. So, traders should not go short on a counter that is in a strong uptrend. Similarly, the RSI in a stock facing a strong downtrend usually moves between 60 and 20, and if it comes close to 60, it can be used for selling short.


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