5 important roles of
Relative Strength Index
(RSI)
Relative Strength Index (RSI) is a momentum oscillator, developed by J. Welles
Wilder, which measures the speed and velocity of price movement of trading
instruments (stocks, commodity futures, bonds, forex etc.) over a specified period of
time.
The objective of RSI indicator is to measure the change in price momentum.
It is a leading indicator and is widely used by Technical Analysts over the globe.
RSI can be used to spot a general trend.
It is considered overbought when it goes above 70 and oversold when it goes below
30
Moreover, RSI can also be used to look for failure swings, divergences and center
line crossover.
Table of Contents
RSI Calculation
5 Important Roles of Relative Strength Index
Trendline Application
Pattern Breakout
Advance breakout and breakdown
Role of 50
Failure swing
5 Important Roles of Relative Strength
Index
Apart from reading overbought and oversold condition, there are certain special features in
relative strength index. Those are as follows-
1. Trendline Application
It is an interesting fact that relative strength index and the closing chart almost go hand in
hand.
Sometimes it becomes difficult to differentiate which one is RSI and which one is the closing
chart.
We apply trend lines in the closing chart may it be up or down.
Similarly, we can apply closing trend lines in the same manner in RSI.
It is interesting to know that RSI trend lines would be broken at least 3-4 days before and this gives an
advanced signal that price is going to break the same trend line within a day or two.
The above is the chart of LIC Housing Finance and as we can see that RSI already gave an
advanced sell signal.
The first sell signal came on 9 May 2017 when RSI breaches the uptrend line and the second
th
sell signal came in on 14 June 2017, when the RSI bounced after breaching the uptrend line
th
and faces a strong resistance from the uptrend line in RSI as shown in the chart.
Soon after the second sell signal came in, the stock corrected about 25% from its high.
2. Pattern Breakout
We know that formation of pattern is an interesting phenomenon in building of the chart. Any
pattern may it be reversal or continuation will stage a breakout at a particular point of time.
It is again interesting to know as RSI considers the underlying relative strength of a stock
over a specified period of time. Such breakout will occur at least 2-3 days in advance in RSI
which price will follow in due course.
The above is the chart of Future consumer where there was a head and shoulder pattern was there in
RSI. At the same time, there was a double top formation at the top and M-top formation in Bollinger
bands which rather confirmed our sell signal. Soon after the RSI line breached the neckline, there was
a good correction in the price.
3. Advance breakout and breakdown
The concept of advance breakout and breakdown works wonderfully in OBV indicator.
The same logic is true also in case of RSI.
Advance breakout implies when the indicator (RSI here) has breached the previous top while
the price hasn’t breached the previous top yet.
So it’s basically an advanced or early signal which indicates that price will also follow the
indicator in the coming few sessions.
The below is the chart of Sanghvi movers, as we closely watch the RSI line, we can see that
RSI already breached the previous resistance but the price still hovering below the previous
resistance.
Soon after the price breakout, the stock witnessed a good rally.
4. Role of 50
In relative strength index, the mid 50 line acts as a very important line to indicate the price
direction.
It is usually seen that the price continue to stay above the mid 50 line during the bullish phase
while it faces strong resistance from the 50 line in RSI during the bearish phase of the market.
However, there may be a lot of whipsaws in the daily chart, so it’s better to look at the bigger
timeframe chart say weekly chart.
The above is the chart of Tata Motors and we can see that whenever the RSI is maintaining
above the mid 50 line, the stock was in the bullish mode while when the price was below the
mid 50 line, the stock showed good correction.
In short, we can say that the mid 50 line in RSI acts as a good trend changer.
5. Failure swing
A bullish failure swing forms when RSI moves below 30 (oversold), bounces above 30, pulls
back, holds above 30 and then breaks its prior high.
It is basically a move to oversold levels and then a higher low above oversold levels.
The below is the chart of Asian Paints where there is a clear failure swing in RSI. Soon after
the resistance got broke in RSI, the stock witnessed a good rally.
A bearish failure swing forms when RSI moves above 70, pulls back, bounces, fails to exceed
70 and then breaks its prior low.
It is basically a move to overbought levels and then a lower high below overbought levels.
The below is the chart of SBI where there is a clear failure swing in RSI.
Soon after the support was broken in relative strength index, the stock saw a good correction
within a month’s time.
