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
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
. 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
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
***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