You will most likely see lines running across a stock chart displayed on a trader’s trading terminal. These lines can be termed as 'Technical Indicators'. A technical indicator is used to help a trader analyze the price movement for security.
Successful traders introduced indicators to the world as independent trading systems. Preset logic is used to build indicators. This allows traders to add technical knowledge (candlesticks volumes, S&R, etc.) to make a trading decision. Indicators are useful for confirming and confirming trends as well as predicting them.
Leading and lagging are the two main types of Indicators. A leading indicator is the one that leads the price. This indicates the possibility of a trend reversal or new trend ahead of time. This sounds fascinating, but not all leading indicators will be accurate. False signals are a hallmark of leading indicators. Traders should be alert when using leading indicators. Trading experience increases the effectiveness of leading indicators.
Oscillators are the most common name for leading indicators. They oscillate within a defined range. An oscillator typically oscillates between extreme values, such as 0 and 100. The oscillator's reading (for instance 55, 70, etc.) will determine the trading interpretation. The trading interpretation can vary depending on the oscillator's reading (e.g. 55, 70 etc.).
A lagging indicator, on the other hand, is one that lags the price. It usually signals the occurrence or a new trend. It may seem counterintuitive to think that a signal can be given after an event has happened. It is better to wait than regret. The moving average is one of the most widely used lagging indicators.
It is possible that you are wondering if the moving mean is an indicator. This is why we have discussed it before the indicators were discussed. Moving averages are a core concept. It is used in many indicators, such as RSI and MACD. We discussed the moving average separately.
Understanding momentum is important before we can understand the individual indicators. Momentum refers to the rate at which the stock price changes.If the stock price today is Rs.100, but it rises to a high of Rs.105 tomorrow, and then Rs.115 on the next day, then the momentum is high. This is because the stock's price has changed by 15% over 3 days.
J.Welles Wilder developed the Relative strength Index, or simply RSI. RSI, a momentum indicator that helps identify a trend reversal, is a key indicator. The RSI indicator oscillates from 0 to 100. Based on the most recent indicator reading, market expectations are set.
The term "Relative Strength Index", while it doesn't compare the relative strengths of two securities, can be misleading. Instead, it measures the security's internal strength. The most widely used leading indicator, RSI, gives the strongest signals in periods of trending and sideways.
Here's how to calculate the RSI:
RSI = 100 - 100
RS = Average gain/average loss
This example will help us to understand the indicator.
With this in mind, let's say the stock trades at 99 on day 0.
|S.n.||Price(closing)||Gain points||Lost points|
In the above table, points gained/lost denote the number of points gained/lost concerning the
Points gained/lost in the table above denote the number or points gained/lost relative to the previous day's close. If today's close was 104, and yesterday's close had 100, then points gained and points lost would equal 4. Similar, points gained and lost would be equal if today's closing was 104 and yesterday's closing was 100. The loses are calculated as positive values.
The default period setting in charting software has been set to 14 data points. We used 14 datapoints for this calculation. This can be termed as the' look-back period'. The default period for hourly charts is 14 hours. For daily charts, it is 14 days.
First, calculate 'RS' or the RSI Factor. The formula shows that RS is the ratio between the average points gained and the average points lost.
Average points gained = 29/14
Average points lost = 10/14
RS = 2.07/0.714
Inserting the value of RS into the RSI formula.
= 100 - [100/ (1+2.8991)]
= 100 - [100/3.8991]
= 100 - 25,6469
RSI = 74.35331
The RSI calculation is quite simple, as you can see. RSI's purpose is to assist traders in identifying oversold or overbought areas. Overbought means that the stock's positive momentum may not last long and could lead to a correction. An oversold stock could indicate that there is a high level of negative momentum, which could lead to a reversal.
You will see many interesting developments in the chart of Cipla Ltd.
The RSI's 14 periods are indicated by the red line under the price chart. The RSI's scale has an upper bound of 100 and a lower bound of 0. If you look closely, you'll see the RSI's range. The chart does not show 100 and 0.
The security should be considered oversold if the RSI reading falls between 30 and 0. This is because the security is ready for a correction upward. Security readings between 70-100 are considered to be overpriced and ready for a correction.
The vertical line starting from the left is the level at which RSI falls below 30. In fact, RSI stands at 26.8. The stock has been oversold,as indicated by the RSI. The RSI value 26.8, in this case, also corresponds to a bullish engulfing structure. This doubles the confirmation that the trader should go long. This should be true for both volumes as well as S&R.
The second vertical line indicates a point at which the RSI turns 81. This is a level that is considered to be overbought. The trader should not be looking for shorting opportunities and should therefore be cautious when buying the stock. If you look closely at the candles, you will see that they form a bearish-engulfing pattern. An RSI of 81 indicates that the bearish engulfing patterns are a signal to sell the stock. This is followed by a rapid and brief correction in the stock.
This example is very nice. It means that both the candlestick pattern as well as the RSI perfectly align to confirm the event's occurrence. Not necessarily this will be the case always. We now have another way to interpret RSI. These are the two scenarios you can imagine:
Scenario 1)Stocks that are in a steady uptrend (remember, the uptrend can last for a few days to years). The RSI will stay in the overbought area for a long period of time. This is because the RSI's upper bound is 100. It can't go above 100. The trader will always be looking for shorting opportunities. However, the stock will be in a completely different orbit. Example: Eicher Motors Limited has a stock that has returned close to 100% year after year.
Scenario 2)If a stock is in a downtrend, the RSI will remain in the oversold area since it is lower than 0. It can't go above 0. The trader will look for buying opportunities in this instance, but the stock will fall lower. Example: Suzlon Energy has a negative 34% annual return.
We can interpret RSI in many other ways than the traditional interpretation, which we have discussed previously.
The parameters used to analyze RSI shouldn't be treated rigidly. J.Welles Wilder chose a 14-day lookback period because it was the most effective considering the market conditions in 1978, when RSI was first introduced. If you want, you can choose to use 5,10 or 20 days, or even 100 day lookback period. This is how you build your trading edge. It is important to evaluate what works for you, and then adopt that same approach. The indicator will be more volatile the less days you spend calculating it.
J.Welles Wilder also used 0-30 to denote oversold areas and 70-100 to denote overbought regions. This isn't a set formula; you can make your own combinations.
Personally, I prefer to use the 0-20 level and 80–100 levels to identify oversold or overbought areas. This is in addition to the 14-day look back period.
You should explore what parameters work best for you.And it can be considered as the best way to succeed in trade.
Remember that RSI is not a standalone indicator used by traders. It is often used in conjunction with other candlestick patterns and indicators for market analysis.