What the RSI Indicator Tells You

By wyatti@bfpublishing.com (Ian Wyatt),

Shutterstock photo

Over the past few months I've written more and more about technical analysis methods here in Small Cap Investor Daily . I feel it's incredibly important for independent investors to have a solid set of tools to help evaluate potential investments. Otherwise we're just following what other people are saying 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.

So today I want to talk about The Relative Strength Indicator (RSI). This is a very easy indicator to turn on when using most finance charting websites such as Yahoo! Finance or StockCharts.com . 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.

***So what is a stock's relative strength? The relative strength of a stock is a measure of a stock's price against its own past performance. It helps to determine the internal momentum and resilience of the stock. Note that this is different than the price of a stock relative to the trends in other stocks in the same industry, or against the broader market. As I mentioned above, the relative strength indicator (RSI) measures the trend I'm discussing today.

This 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.

***A key momentum indicator, the RSI is used to time entry and exit decisions based on momentum. For example, a stock that has a low but improving RSI could be building strength. Momentum investors may see this change as an early sign that the stock is going to outperform the market in the future.

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.

The chart below is of a small cap stock I added to the Small Cap Investor PRO portfolio last week. The blue line is the 50-day moving average, the red line is the 200-day moving average, and the black line in the bottom chart is the RSI, set to 14-days. You can see that RSI recently crossed above 50, a sign of strength. Investors should be on the lookout for these signals, and use the knowledge to help time entry and exit points on particular stocks.

Incidentally, I added the stock in the chart above partially because it pays a fat dividend - nearly 10 percent. I just put together a special report that includes two companies paying dividends over 9 percent. You can learn more here .

***It is important to keep in mind that technical indicators are generalizations, and none by themselves can be used reliably to make specific trading decisions. But used in groupings, technical indicators like RSI are effective tools for timing of entry and exit. In addition, technical indicators 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 time.

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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing Stocks
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