RSI: How to read the trend-spotting indicators such as MACD, RSI

The MACD or moving average convergence divergence and RSI or Relative Strength Index are both trend-following momentum indicators that show the relationship between two moving averages of a stock. These two indicators are widely used by both novice and experienced traders.

The beauty of the RSI is that it can be combined with a number of other indicators and can support different trading approaches and strategies. We need to understand that RSI is a leading oscillator, which means it shows the potential future changes in the price of a stock or index.

The MACD, on the other hand, shows the strength of the trend as well as its direction. The MACD is the difference between a short and long exponential moving average (usually 12-day and 26-day periods). A nine-day period’s exponential moving average of MACD, called the Signal Line, is plotted on top of the MACD to show buy/sell opportunities. These MACD moves in and around the zero line. This gives MACD the characteristics of an oscillator, which results in overbought and oversold signals above and below the zero-line, respectively.

The MACD proves most effective in a widely swinging market, whereas the RSI usually tops out above the 70 level and bottoms out below 30. It usually forms these tops and bottoms before the underlying price chart.

Being able to interpret their behaviour can make trading easier for a day trader. First, let’s try to read between the lines of the MACD.

MACD line (blue) crosses the zero line: When MACD line (blue) crosses the zero line, from bottom to top (MACD line enters the positive zone), it indicates strength. When the indicator enters the negative zone below zero, it means the bears have the momentum with them.
MACD line (blue) crosses the MACD signal line (red): When the MACD crosses the Signal Live during an uptrend, it’s a strong buy signal. When it moves down and crosses the Signal Line from top to bottom, it indicates weakness.

Histogram (white) crosses the zero line: The bars located in the positive zone show the power of a bull run. Here, the highest numbers mean the most possible reversal. It works similarly when the bars are below the zero line, when it favours the bears. At the same time, we need to understand that a wide distance between the three lines (MACD, Signal Live, Zero Live) may mean the market is overextended and a correction is due.

On the Contrary, as said earlier, the RSI shows the power of current market ‘buy’ or ‘sell’ actions. It can be used to amplify trading strategies by making more informed decisions on entry and exit points. Like most technical indicators, its signals are most reliable when they conform to a long-term trend.

The RSI will rise when the number and size of positive closes increase, and it will fall when the number and size of losses rise. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100. Let’s understand that when the RSI enters the oversold zone (70), this would indicate a good time to sell (or hold if you are keeping it as a long term investment).

Trading strategies based on the MACD and RSI are a straightforward system based on these indicators with the goal of identifying trends and opening/scalping positions according to a trend direction. However, both the indicators, have the differences.

RSI and MACD are both measurements that seek to help traders understand a stock’s recent trading activity. However, both accomplish this goal in different ways. Both the indicators measure market momentum, but they measure different factors, and hence sometimes give contrarian indications.

(DK Aggarwal is the CMD of SMC Investment and Advisors)