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DEFINITION:
The Relative Strength Index (RSI) is a tool that helps investors predict whether an asset’s price might rise or fall in the future based on recent price changes.
Understanding Relative Strength Index (RSI)
Investors do not have a crystal ball, but they also do not have to rely on blind guesswork to predict when a stock’s price will rise or fall. The relative strength index is a tool that active traders can use to predict how stocks or other assets will perform in the future. Developed in 1978 by analyst James Welles Wilder Jr, the RSI measures how quickly and drastically an asset’s price has changed recently. This can help traders assess whether stocks are overvalued (trading above their actual value) or undervalued (trading below their actual value). Undervalued stocks may soon see a price increase, while overvalued stocks may see a decrease. Knowing this information can help investors decide when to buy or sell securities to make a profit. RSI is an imperfect indicator and is best used in conjunction with other tools. However, there is no guarantee that it will lead you in the right direction, and trading inherently involves risk.
EXAMPLE:
let us say a shoe store starts selling the latest must-have model for $50. As the model becomes more popular, the store increases the price by $5 per day. After two weeks, the shoes cost $120. If the model is really only worth $50 (based on the price in other stores, for example), you might conclude that the shoe is overpriced at that retailer. You would think twice before investing in a pair because you would predict that the store would lower the price in the future (although there is no guarantee that you would be right). You may not have a fancy chart handy, but you do the same thing as a trader who consults an asset’s relative strength index: you track recent price changes to predict future ones, and make investment decisions accordingly.
Takeaway
Using the Relative Strength Index is like trying to predict the next sale at your favourite clothing store…
If you’ve been following the recent price changes for the sweater you’ve been eyeing, you may be better able to predict how much it’ll cost in the future. This way, you can try to buy it at the best time. There’s no guarantee that you’ll make the right decision, but you’ll probably be in a better position than if you blindly went to the store and made the purchase.