It's incredibly important for investors to have a solid set of
tools to help evaluate potential investments. Otherwise we're just
following what other people say without using our own brains - a
sure-fire way to lose money. Independent investors need to think
for themselves, and act according to their own research.
Technical analysis methods blended with fundamental research is
the best combination of tools. Over the next couple of weeks I'll
review a number of technical analysis tools that you can use to
help time your buy and sell decisions.
Today we'll take a look at the relative strength indicator
(RSI). The relative strength of a stock is a measure of a stock's
price against its past performance. It helps to determine the
internal strength of the stock.
It's a very easy indicator to turn on when using most finance
charting websites such as
. On Yahoo! Finance, use the 'interactive chart' feature and look
in the drop-down tab for 'technical indicators'. You can set the
RSI to the period of your choice. Note that it will be in the same
period as the one you select for your chart, days for a daily
chart, weeks for a weekly chart, or minutes for a minute chart. I
suggest sticking with 14 days and 3-month, 6-month, and one year
charts until you become accustomed to using the index.
RSI is a technical momentum indicator that quantifies the
magnitude of gains and losses to determine whether the stock is
overbought or oversold. The formula for relative strength is: RSI =
100 - (100 / (1 + RS)). In this formula, RS = (average of (x) days
up closes) / (average of (x) days' down closes).
The RSI of a stock is useful only when the relative trend is
observed over a period of time. The scale is set from 1 to 100, and
when RSI rises to 70, it indicates that the stock could be getting
overbought. Conversely, if the RSI drops below 30, the stock could
be getting oversold and you may want to accumulate shares. The
appeal of this barometer is that it enables you to apply a simple
formula to draw a meaningful conclusion about the price strength of
a single stock.
Take a look at the three month chart of
Green Mountain Coffee Roaster (Nasdaq: GMCR)
below. This stock has been selling off and rallying due to
fundamental reasons, but the RSI indicator has been fairly accurate
in signaling when the stock should rise (RSI hits 30) and fall (RSI
A key momentum indicator, the RSI can be used to time entry and
exit decisions based on momentum. For example, a stock that has a
low, but improving, RSI may begin to show signs of strengthening
stock price. Momentum investors may see this change as an early
sign that the stock is going to outperform the market in the
Another advantage to using RSI is that it can be calculated over
any time period. Very short-term traders may track RSI over just a
few minutes, whereas traders willing to wait for longer time
periods may want to use RSI over several months. As I mentioned
earlier, start with using a 14-day period on 3-month, 6-month and
one year charts and go from there depending on your preference.
The key change in RSI, represented by strengthening or weakening
trend lines or even crossover points (with other indicators like
moving averages), is believed by many technicians to anticipate
more specific signals like breakouts and strong price reversals.
RSI, accompanied by observation of changes in the patterns of
trading ranges and resistance or support tests, can serve as an
important early indicator of new trends in a stock's price.
But be careful, the more indicators you use the more confusing
things can become when first starting to use technical indicators.
Ease into it by adding one, then two indicators and you'll learn
faster than adding everything all at once.
All technical indicators are generalizations, and none by
themselves can be used reliably to make specific trading decisions.
They can be used to confirm emerging fundamental trends in a
company's ever-changing competitive stance. The best approach to
studying a company is utilizing a wise combination of fundamental
and technical indicators, and tracking both types over a period of
Just like most things, understanding technical analysis measures
like the relative strength indicator takes practice. But to a
trained eye, RSI can give the astute investor an idea where the
stock price may go. Practice before you act, and gain confidence.
You'll be glad you did when you start to make profitable
investments and trades.
I've been using the RSI indicator to help time entry points for
Small Cap Investor PRO
recommendations. Right now our last seven recommendations are up an
average of 46.4 percent, and two have returns over 100 percent!
Click here to learn more, and find out why small
cap stocks ALWAYS outperform.