ABCD of RSI Indicator
First, understand the meaning of Overbought and Oversold.
These terms are even practical? How can anything be overbought when we have more buyers and vice-versa is oversold.
Imagine if you were selling potato and its current price was 40₹/ KG. Now, imagine soon it will get more and more buyers. So can you guess what will happen when demand is high? Yes, the price will go high as supply is limited. So now the price of potato is 50₹/kg. The more demand price will go to 60, 70 and then 100₹ /KG.
Now comes our concept—how many people will pay 100₹ for just one kg of potato. Possibly very less than those who were paying when it was 40₹. So now demand has fallen, and we faced an OVERBOUGHT situation. Exactly the opposite situation will be there for the OVERSOLD situation when demand keeps falling and prices go down, but at one point the lowest price will attract more people, and we will call it the OVERSOLD situation.
Overbought and Oversold point in stock market?
Demand and supply theory will be applicable in any market, not just the stock market. Imagine if any XYZ stock or Gold or even crude oil is going for a one-sided Trend for long. Now, in an Overbought situation, when demand is more, sellers will make an entry at some point, and in the case of an Oversold situation, buyers will make entry as well sooner or later. So if we find such points, then we will not just understand trend reversal, but it will also help us to make a fresh investment when the entity is oversold or even book our profit when it’s overbought. But how to identify such points. That’s why we have the RSI Indicator.
What is RSI Indicator?
The full form of RSI is Relative Strength Index. It’s not the price or any pattern, it’s an index which tells you the strength for upside and downside of both.
Before we understand how to use it, let’s see how to add RSI indicator in Upstox and Zerodha.
- Click on any stock and open its chart , you will see +fx button.
- Once you click on the RSI then the indicator will show default numbers like period =14 , keep it as it is.
- Just like Zerodha, in the UPSTOX app click on any stock, and once chart opened click on +fx button.
- search using word RSI, once it opens from the list just click on it. It will get added automatically.
What is the use of RSI Indicator
Now comes the important thing , how to make use of this RSI Indicator ??
When you add RSI in your chart you will see it like this 👇👇👇
As the period is 14, then the black line in the RSI indicator tells you strength on both the up and downside of the stock for the last 14 days if daily chart. Or 14 weeks if weekly chart and so on.
Can You see two horizontal lines? One at 80 and the second on the downside at 20. These two are Indicator of Overbought and oversold entity. So anything above 80 is overbought stock, indicates to book your profit, and below 20 is the indication of buying fresh Investment.
Also, note when the black line is above 60 it’s a Bullish indicator and the moment it slides below 40 its bearish sign.
Let’s see Examples of RSI
It was due to the vaccine news that Glenmark was Super bullish , and due to same Bullishness anyone might come up with a target of 600-650 or even more in the coming days. But check the RSI, it was above 80, which clearly suggested stock was overbought, and that’s why stock made a sharp fall next day
It was near March 2020, there was a big fall in the market and so in LT . Now LT is not a bad stock fundamentally. But at what point we have to buy, RSI helped here as well. RSI went below 20 when stock was near 750 suggesting stock was OVERSOLD. And it turned out it was the best price, eventually the stock recovered in the coming months touching the 1000+ mark.
Limitations of RSI
Is it as simple to buy the stock when RSI goes below 20 and sell it when it goes above 80? The answer is yes, it’s that simple. But we have one limitation here, let’s see with an example.
This is Laurus labs stock chart, see above picture.
What you see from the above picture? Stock is overbought not just for 1-2 days but for 10 weeks and yet no sign of fall.
So the limitation here in RSI is it won’t tell you exactly when the trend reverses when the stock is overbought or oversold. It might reverse before touching 80 or before going down below 20. It will reverse for sure when oversold or overbought, but it’s not a price action Indicator, that’s why it won’t tell you the exact day. But it will reverse, more duration to reverse means the reversal will be much stronger in stock. It’s very rare, but it will happen when stock is following only Sentiment of news/ event of the duration.
Solution is you already know there is a reversal, but the best play is to pair RSI with MACD crossover or candlestick signs just for confirmation of an ongoing trend.
What we have learned so far
1. Be it the price of Potato or stock when it follow demand and supply theory.
2.When demand keeps rising, then at one point it gets into the overbought zone and vice-versa for the oversold zone.
3. Name of Indicator which help us to find when a stock is overbought or oversold is RSI.
4. RSI is Relative Strength of stock, it follows data of past duration, not current price action.
5. If RSI is Above 60, stock is bullish, below 40 stock is bearish.
6. If RSI is above 80 stock is Overbought and if RSI is below 20 stock is oversold.
7. Bullish stock may reverse when RSI is 65 or 70 or 78 without touching 80 value or Bearish stock may reverse when RSI is 32 or 27 or 21. Without going below 20.
8. It’s also possible stock might stay in the Oversold or overbought zone for a longer time. In this case Reversal when it comes will be very strong.
9. To confirm a reversal sign, it’s wise to pair RSi indicator with MACD , Candlestick to identify ongoing trend much accurately.
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