Understanding RSI and Market Strength

CA Manish Singh: 
Hello everyone, and welcome to Chapter 12. In this chapter we will discuss an important momentum indicator used across global markets, known as the Relative Strength Index or RSI. RSI helps you identify the strength of a trend, judge whether a support or resistance level may hold, and spot potential reversals. 

What This Chapter Covers 

• What RSI is and how it works
• How to read RSI levels
• Understanding strength and exhaustion in trends
• RSI divergence and what it signals
• How RSI helps you judge breakouts and breakdowns 

What Is RSI and How Do We Use It 

CA Manish Singh: 
Earlier, when we discussed pivot points and moving averages, I explained that trends become meaningful only when we understand their strength. RSI is the most widely used indicator globally because it measures this strength. 

To view RSI on the chart, go to Indicators and search for Relative Strength Index. Once applied, you will see two important levels by default: 30 and 70. These act as lower and upper bands. 

However, modern markets often move in extremes, so we adjust these levels to 20 and 80. 

• Above 80 suggests overbought conditions.
• Below 20 suggests oversold conditions. 

When you change the timeframe, the strength displayed by RSI also changes. 

• On a 5-minute chart, RSI reacts quickly to intraday moves.
• On a 1-day chart, RSI reflects longer term strength or weakness. 

For example, a stock may show RSI around 34 in a 5-minute chart but around 60 on a 1-day chart. This difference comes from the timeframe you choose. 

How RSI Reflects Strength and Weakness 

CA Manish Singh: 
If RSI remains very low, around 20 to 25, it suggests strong selling pressure. After a sharp fall, RSI often flattens near the bottom, showing that the market has lost downward momentum. When the RSI stops falling and starts turning upward, it indicates that the market is trying to regain strength. 

Similarly, when prices rise sharply: 

• RSI moves towards 70
• Then towards 80
• And often fades near these levels 

Once the RSI reaches extreme levels, buying strength weakens and the trend may pause or reverse. 

If you see the market approaching resistance with RSI already near 75 or 80, the probability of a breakout reduces because the trend has exhausted itself. 

If the market approaches support with RSI near 20 or 25, the trend has likely exhausted its strength and may bounce. 

Understanding RSI Divergence 

CA Manish Singh: 
Divergence is one of the most powerful signals of RSI. 

RSI divergence occurs when: 

• Price makes lower lows, but
• RSI starts making higher lows 

This shows that although price has not yet reversed, buying strength is increasing beneath the surface. This often precedes a reversal. 

Similarly: 

• Price makes higher highs, but
• RSI begins making lower highs 

This suggests the market is losing strength. The trend may be slowing and a reversal becomes possible. 

RSI divergence does not mean the reversal will happen immediately, but it signals that the underlying strength of the trend has shifted. 

How RSI Helps You Judge Breakouts and Breakdowns 

CA Manish Singh: 
RSI is closely connected to support and resistance. Before a breakout or breakdown happens, RSI usually signals whether the market has enough strength to push through. 

Examples: 

• Market approaching resistance with RSI around 40 to 60 means the trend may still have strength to rise further towards 70 or even 80.
• If RSI is already near 75 or 80, the probability of breaking resistance becomes lower.
• Market approaching support with RSI around 45 still has room to fall to 30 or 20.
• If RSI is already near 25, support is less likely to break because the market is already exhausted. 

This is how RSI helps you take informed decisions at key levels. 

Summary and Takeaways 

• RSI measures the strength of the market trend.
• Use 20 and 80 instead of 30 and 70 for modern market conditions.
• RSI near 80 suggests exhaustion in an uptrend.
• RSI near 20 suggests exhaustion in a downtrend.
• RSI divergence indicates the trend may reverse.
• RSI helps you judge whether support or resistance may break. 

In the next chapter, we will learn about another popular momentum indicator built on moving averages: MACD or Moving Average Convergence and Divergence. 

Disclaimer: Investments in securities markets are subject to market risks. Read all related documents carefully before investing.