For those new to trading and investing, there are a bewildering number of theories, techniques, and analyses available. Some are based on obscure math, some on observable events, and some seem to be based on nothing in particular.
There are those that, for whatever reason, seem to work often enough to make them useful. Relative Strength Index (RSI) is in that group.
Chart reading and technical analysis has been around since the advent of traded markets. It is generally traced back to agricultural commodities in 16th century Europe and Japan. In America it really started with Charles Dow towards the end of the 19th century, but even by that standard, RSI, which was first introduced by J. Welles Wilder in 1978, is a newcomer.
Still, it has been around long enough to be seen as passing the test of time, and if used properly, can be a good indicator for traders and investors alike.
It is what is known as a “momentum oscillator” which simply means that it measures momentum on a graph. It is used to identify when that momentum has reached an extreme and is therefore likely to shift. It is expressed as a number between 1 and 100, with 30 and 70 considered to be the levels that indicate a probable reverse.
A reading of 30 indicates that a stock or whatever is oversold, with 70 suggesting it is overbought.
The number is a representation of the relative strength of upward moves to downward moves during the last fourteen time periods. The last fourteen results are then averaged to smooth out the graph. The periods can be as short as one-minute for intraday traders, or one day or more for those with a longer time horizon.
For the sake of simplicity here, I will stick to one day periods.
The exact formula for its calculation isn't really necessary because it can be plotted on just about any brokerage's trading platform with a click of a button. The logic behind it is straightforward enough: Prices move based on how committed buyers and sellers are and that can be measured by how big the drops and jumps are each day over a given time.
As I said, a reading below 30 is considered oversold and 70 overbought, but, over time, analysis has shown that just hitting those marks once is not necessarily reliable. False signals are a problem with any indicator, and to cut down on those when using RSI, it is better to wait for two indications in a row in the same direction.
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On the above chart, for Exxon Mobil (XOM) with one day candles since September 1, the buy signal would come on the second break of the 30 line, or rather the break back above the line that follows it. That is actually an important distinction. Momentum can be powerful and, “oversold” or not, one should always remember the old traders’ saying that the market can stay illogical a lot longer than you can stay solvent.
Waiting for the line to break back above the indicator level means that you act only when that momentum has reversed. In this case it would have led you to buy at around $65-67, which, as you can see, would have been a good trade.
There are a couple of things that should always be remembered. RSI is more reliable as an indicator than many others, but it not infallible. It is therefore important that it be used in conjunction with stop-losses. Waiting for momentum to shift allows you to use the low as a level off which to set those orders, which will usually keep losses manageable. In the example above that would mean a stop at around $62-63.
As to a target level, it makes sense to use a double cross of the opposite indicator line as a cue to exit the position. In the case of XOM, that would have come a few days ago and you would take a profit at around $79.
It is also important to use RSI analysis in conjunction with a basic understanding of the fundamental factors that are causing a selloff. If the company concerned is in real trouble or is in an industry that is in terminal decline, no technical indicator should be considered a buy signal.
With those provisos though, RSI can be a useful tool for identifying opportunity and a basic understanding of it can help you make smarter decisions.