Relative Strength Index (RSI)
If you ever wanted a signal that can help you perform better. The Relative Strength Index (RSI) will be your best friend.
The relative strength index (RSI) is a momentum indicator that measures the days of upturns and downturns during a specific period, e.g 14 or 21 days. The idea is very simple and the indicator was originally developed by J. Welles Wilder, who published in his book "New Concepts in Technical Trading Systems" for the first time in 1978. If a stock is moving up or down too many days in a row the chances of an opposite reaction increase. However, when is a stock really oversold or overbought?
To solve this question J. Welles Wilder, who was a machine engineer, turned to mathematics and created the RSI formula, which gives a score between 0-100. He later assigned values under 30 as “oversold” and above 70 as “overbought”. This is normally marked as red for the priceline of overbought and green for the priceline of oversold.
Boeing Company being overbought on RSI 14 in end of September
Now you probably think that you found the secret formula for profitable trading. Well, it is not that simple and again you will lose money if you just jump to the idea. There are a few catches you need to understand before taking full advantage of the RSI-tool.
It makes sense that people are less negative in an upturn market. The sentiment is positive and beliefs are strong. Everything is possible if you are in a good mood and usually this reflects in the stock market as well. Very often stocks and even the whole market itself, can go long and hard in overbought (RSI higher than 70). So what conclusion can be made from this? Well… Overbought is not simply overbought. In fact you will be better of if you say that overbought is when the assigned value is higher than 80 with an upward trend, and oversold is when the assigned value is less than 40. It is the total opposite in a negative trend. Then RSI above 70 really is “oversold”. The reason for this is very logical and simple. If a stock is already in a falling trend there is a general overweight of negativism and it takes less to trigger further fall. And if you are feeling negative first, well, then it takes a long time for you to be positive, so stocks in a falling trend can stay oversold longer than normal.
Snap being oversold for almost 2 months!
To make it even worse. There is a huge individual difference from stock to stock. General volatile stocks (like penny stocks) statistically stay oversold and overbought longer than e.g. solid stocks like Apple. Again it all comes down to strategy and you need to define it yourself. If trading by RSI is in your strategy it should be clearly defined like:
“I will buy stocks in an upwards trend and use oversold RSI as entrance point”.
Now what you will need to do is scan market for all stocks in a rising trend with low RSI. This can be done at e.g Stockinvest.us. You will then have a list of candidates matching your request. However, still half of the job is done. You need to take in consideration the individual patterns for each stock. The best way to do this is just by looking at the chart. How did the stock behave in the past when being oversold? Does it usually react up quickly or can it be oversold for a long period? What is the most common reaction? Just 2-4% reaction up or 20%? There is no point in being a day trader buying a stock on oversold RSI if it usually uses very long time to gain even 5%. In general, RSI is better as long term signal than a short term indicator.
In the sample above FB was oversold a few days ago. The same situation happened back in September. At that point the stock gained from USD 160 to USD 168 or approx 5%. It has now already taken out about the same gain and being in a falling trend this is still no “buy case”. Analyzing history in your trading is essential, but you should be aware that patterns changes, so always take this into consideration. It may very well be that FB now will gain 40%, but statistically the chances are higher that it will continue to fall. Where do you put your gamble? Why not go for a safer bet?
So what is the lesson about RSI?
RSI can be measured in different time frame. The most common is 14 and 21, whereas 14 is short term and 21 long term.
RSI is in general more predictable as long term signal.
The RSI-effect depends on the trend direction.
The RSI-effect differs from stock to stock. Volatility matters.