TRADING MANUAL - Using Relative Strength Index (RSI) to trade 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.

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'.

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.

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.