The Hindu Business Line : Relative strength index

The Relative Strength Index (RSI) oscillator determines the strength in the prevailing trend by comparing the magnitude of a stock’s recent gains to the magnitude of the recent losses. The graph below shows the RSI plotted below the price chart. The RSI oscillates between the values of 0 and 100. Between 0 and 30 is the ‘oversold’ zone. When the RSI declines to this zone, it means that the selling might have been overdone and an upward reversal could be around the corner. However, the RSI can stay in the oversold region for prolonged duration. There is no hard and fast rule on the duration for which RSI should feature in the oversold or overbought territory.

Refer to the chart of Sadbhav Engineering. The RSI entered the oversold region in June and remained below 30 till mid-July 2008. The stock price continued to decline during this periodIn November and December 2008, both the stock price and the RSI were declining in tandem. The RSI entered the oversold region in this period and recorded a low at 12 before reversing higher. Thus, it cannot always be concluded that the stock price will reverse upward just because the RSI has entered the oversold region. The indicator can stay oversold for extended periods while the stock continues declining.

Similarly, above 70 and below 100 is the ‘overbought’ zone. The RSI reaching this zone implies that the stock may be getting overvalued and a pullback or correction is likely soon. From the RSWM chart, it is clear that the RSI remained in the overbought region for a prolonged period in December 2007

It is, therefore, not appropriate to initiate long positions based on the observation that the RSIhas reached the oversold territory. Similarly, short positions cannot be taken as soon as the RSI reaches the overbought region. A trend reversal ought to be confirmed by a reversal in the RSI or RSI moving out of the oversold or overbought region.

More Stories on : Technical Analysis | Stock Markets | Young Investor

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page