Previous issues covered momentum indicators such as rate of change (ROC) and moving average convergence divergence (MACD). This edition introduces the relative strength index (RSI), one of the most popular technical indicators.
Computation: RSI is computed based on the speed and direction of a stock’s price movement. This means that the RSI indicator only measures the stock’s internal strength (i.e. based on its own past) and should not be confused with its relative strength with other stocks, market indices, sectoral indices, etc.
The RSI is calculated using a two-step process. First, the average gains and losses are identified for a specified time period. You can consider any time period, but 14-day RSI is the commonly used. During the last 14 days, suppose that the stock went up on nine days and fell on five days. The absolute stock price gains 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).
Second, the indicator is normalised later to make sure that the RSI always moves between 0 and 100. The RSI value will be 0 if the stock fell in all the 14 days and will be 100, if the price moved up on all the 14 days. The formula used for this process is given below: RSI = 100 – [100 / (1+RS)]
Overbought / oversold levels: Since the RSI value is designed to move between 0 and 100 always, it can be used to identify the overbought and 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 example, these levels may never get breached in stable stocks like ITC for several months (see charts for details). However, the same may get broken regularly in volatile stocks.
So, it is always better to fix these overbought / oversold levels after watching the RSI for several months.
Source: Economic Times