If you look at a stock chart displayed on a trader’s trading terminal, you are most likely to see lines running all over the chart. These lines are called the ‘Technical Indicators’. A technical indicator helps a trader analyze the price movement of a security.
Indicators are independent trading systems introduced to the world by successful traders. Indicators are built on preset logic using which traders can supplement their technical study (candlesticks, volumes, S&R) to arrive at a trading decision. Indicators help in buying, selling, confirming trends, and sometimes predicting trends.
Indicators are of two types namely leading and lagging. A leading indicator leads the price, meaning it usually signals the occurrence of a reversal or a new trend in advance. While this sounds interesting, you should note, not all leading indicators are accurate. Leading indicators are notorious for giving false signals. Therefore, the trader should be highly alert while using leading indicators. In fact the efficiency of using leading indicators increases with trading experience.
A majority of leading indicators are called oscillators as they oscillate within a bounded range. Typically an oscillator oscillates between two extreme values – for example 0 to 100. Based on the oscillator’s reading (for example 55, 70 etc) the trading interpretation varies.
A lagging indicator on the other hand lags the price; meaning it usually signals the occurrence of a reversal or a new trend after it has occurred. You may think, what would be the use of getting a signal after the event has occurred? Well, it is better late than never. One of the most popular lagging indicators is the moving averages.
You might be wondering if the moving average is an indicator in itself, why we discussed it even before we discussed the indicators formally. The reason is that moving averages is a core concept on its own. It finds its application within several indicators such as RSI, MACD, Stochastic etc. Hence, for this reason we discussed moving average as a standalone topic.
Before we proceed further into understanding individual indicators, I think it is a good idea to understand what momentum means. Momentum is the rate at which the price changes. For example if stock price is Rs.100 today and it moves to Rs.105 the next day, and Rs.115, the day after, we say the momentum is high as the stock price has changed by 15% in just 3 days. However if the same 15% change happened over let us say 3 months, we can conclude the momentum is low. So the more rapidly the price changes, the higher the momentum.
14.1 – Relative Strength Index
Relative strength Index or just RSI, is a very popular indicator developed by J.Welles Wilder. RSI is a leading momentum indicator which helps in identifying a trend reversal. RSI indicator oscillates between 0 and 100, and based on the latest indicator reading, the expectations on the markets are set.
The term “Relative Strength Index” can be a bit misleading as it does not compare the relative strength of two securities, but instead shows the internal strength of the security. RSI is the most popular leading indicator, which gives out strongest signals during the periods of sideways and non trending ranges.
The formula to calculate the RSI is as follows:
Let us understand this indicator with the help of the following example:
Assume the stock is trading at 99 on day 0, with this in perspective; consider the following data points: