RSI Stands for Relative strength Index and is basically a momentum OSCILLATOR.
The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, New Concepts in Technical Trading Systems
In the world of technical analysis, most of the Indicators are lagging, but Oscillators are an exception.
Since RSI is also an oscillator, this falls under the category of Leading Indicator.
Now as the word leading suggests, this indicator helps you forecast trend and enter a trade at the right time to catch the trend.
This Blog on RSI will be in 3 parts.
This is the first one:
And this will help you understand the basic concept and working Mechanism of RSI
Let’s get started:
Let’s try to understand why RSI is called a leading indicator with this simple example :
Imagine you are in a Bus, and the windows are non-transparent (Opaque) and assume the only driver can see the road and you as a passenger has no view to the outside world.
How would you forecast the journey?
You have to predict the nature of the road but without any outside view. Is it possible?
The answer is Yes!
Just be sensing the speed at which my Bus is going.
If the bus is going at a very good speed I may assume that the road ahead is very good and clear, perhaps, Highway!
Similarly, if Bus is going at a slow pace, there can be many reasons, It may be due to Bad road, traffic or we reach our destination.
Irrespective of the reasons, by sensing the speed of the bus, I can forecast the journey.
Similarly, by sensing the momentum (speed) of the stock we can forecast the road map of that stock and hence RSI is called as leading Indicator.
The working mechanism of RSI is exactly the same as the Speedometer of a car.
These are the components of the speedometer of a car.
similar to Green and Red zone In speedometer we have same zones in RSI called as oversold and overbought zone respectively.
And just like a needle in speedometer oscillates between these two zones we have RSI line oscillating in these zones.
Based on the movement of RSI we generate entry and exit signals.
BUY RULE : If RSI goes below 30 and takes a U-TURN BUY!!!
Sell RULE : If RSI goes above 70 and takes a U-TURN SELL!!
This is explained in the charts below:
The formula to calculate RSI is :
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]
In the next lesson, we will learn the advanced concept
Watch the full explanation video here :
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