RSI Indicator
When you look at the stock charts, you may find auxiliary indicators at the bottom. What do they stand for? Why do we need it?
The only purpose of stock charts is to make money. Investors want to predict the future direction of stock prices by reading the price trend, and auxiliary indicators are made to read the stock price trend easily.
In this article, we will take a look at the RSI, one of the most frequently used indicator.
What is RSI?
The RSI is a abbreviation of Relative Strength Index. It is designed to measure strength of stock price. The RSI can be obtained by calculating increases and decreases for certain period of time respectively, and count the ratio of how large the increase than decrease. It's easier to understand when you look at the formula.
$RSI=\frac{AU}{AU+AD}\times 100$
$AU_{t}=\frac{(w-1)}{w}AU_{t-1}+\frac{1}{w}UP_{t}$
$AD_{t}=\frac{(w-1)}{w}AD_{t-1}+\frac{1}{w}DOWN_{t}$
Let's see how calculate RSI using 3 days prices.
| Day | Price | Change | Up | Down | AU | AD | RSI |
|---|---|---|---|---|---|---|---|
| 0 | 10 | - | - | - | - | - | - |
| 1 | 11 | 1 | 1 | 0 | - | - | - |
| 2 | 10 | -1 | 0 | 1 | - | - | - |
| 3 | 9 | -1 | 0 | 1 | 0.33 | 0.67 | 33 |
| 4 | 10 | 1 | 1 | 0 | 0.56 | 0.34 | 56 |
| 5 | 11 | 1 | 1 | 0 | 0.7 | 0.3 | 70 |
Let's see how calculate RSI using 3 days prices.
We can calculate RSI from day 3. On day 3 AU is $\frac{(1+0+0)}{3}=0.33$ , AD is $\frac{(0+1+1)}{3}=0.67$, RSI is $\frac{0.33}{(0.33+0.67)}\times 100=33$.
Calculation method of AU and AD changes from day 4. We add today's price to previous day's RSI and average them. AU is $\frac{((3-1)\times0.33+1)}{3}=0.56$ , AD is $\frac{((3-1)\times0.67+0)}{3}=0.44$ , RSI is $\frac{0.56}{(0.56+0.44)}\times100=56$.
The RSI value ranges from 0 to 100. As the price is stronger, RSI becomes larger. If the RSI is 100, it means the prices just have risen during the calculation period.
Then, how the RSI is used in trading?
Welles Wilder, the creator of RSI indicator, defined RSI over 70 as over bought, under 30 as over sold. Over bought means investors are buying too many that market is overheated, and over sold is the opposite. Because we make money by buying in low price and sell in high price, we can buy when RSI is under 30 and sell over 70.
The indicators are useful to understand stock price trends easily. However, it is absolutely dangerous to depend on just one indicator. Even if it is a famous strategy, it should be applied to investment after checking it for yourself. Otherwise it becomes just a gambling if you just follow others.