Easy Steps to Understanding This Popular Indicator
Yesterday we began discussing RSI.
Just to recap:
The relative strength index, or RSI, is an indicator that helps you figure out how a stock’s losses and gains stack up against each other.
The RSI is an oscillating metric.
This means that, based on the most recent price action of a stock, it will change.
The RSI is shown on a scale from 0 through 100. A low RSI can show signs that a stock is underbought, and a high RSI can show signs that it’s overbought.
This can help you find signs of breakouts or breakdowns, and can be used to help confirm trends.
Perhaps best of all, RSI is easy to include in your technical analysis, since it’s a standard indicator on a bunch of different stock screeners.
We left off talking about some tips for using RSI. Let’s finish up with those today…
Rely on Multiple Sources
Like any other technical indicator, the RSI should not be seen as the be-all end-all. It should be used in combination with other technical indicators and a combination of fundamental research to make a case for your trade.
Be smart! Don’t just blindly trade based on the RSI calculation. Decide on the viability of a trade based on a variety of different factors.
Use It to Find Entry and Exit Signals
Rather than looking at the RSI as a definitive sign of whether you should take a position in a trade, consider it a helpful way to plot out potential entry and exit signals for stocks on your watchlist.
Part of the idea behind the RSI is that when prices rise quickly and momentum is high, that eventually the stock in question will be considered overbought. This could help inform when to sell.
The opposite could also be true: A price dropping in a short term and low momentum could offer a potentially opportune time to buy.
Bottom line here: If a stock is already on your watchlist and you’ve been waiting for the right time, the RSI can help you decide when.
Beware of False Signals
Like any other indicator, the RSI has its imperfections. One is that can’t specifically discern a divergence between price and momentum.
A strong uptrend or downtrend could keep the RSI above 30 or below 70, for example. In this case, if you’ve been waiting for the RSI to reach a certain level, you could be left in the lurch.
This is why you want to use the RSI as only one piece of your puzzle when building a case for a trade. It doesn’t tell the full story, and you need to learn to think for yourself so that you can use these numbers rather than just relying on them.
For example, you might find by looking at the RSI but then waiting for a pullback is a strategy that works well for you.
RSI and Stochastic Oscillator
The RSI is often confused with another indicator called the stochastic oscillator, so let’s take a minute to discuss the difference.
What are Price Momentum Oscillators?
But of course, before we go into the stochastic oscillator, we need to backup a little further still, because you need to understand what a momentum oscillator is, to begin with.
A price momentum oscillator is a measure between the amount that a stock’s price has changed within a period of time.
The stochastic oscillator is a specific type that compares the stock’s losing price against its trading range over a time period. The number is expressed between 0 and 100, and it’s usually shown along with a SMA (simple moving average) of itself.
The standard number of periods for the stochastic oscillator is 14. So if you’re looking at daily candlesticks, it will be shown as SO(14) on a chart. If you’re looking at minute candlesticks, it will be based on the last 14 minutes.
So, what does the number mean?
If the number is between 0 and 50, that means the stock closed in the lower part of its trading range. From 50 to 100 means it closed on the higher end of its trading range. The closer to 0, the closer to its low; the closer to 100, the closer to its high.
Like the RSI, the stochastic oscillator is used to figure out a stock’s momentum, and is also used to figure out if a stock is overbought or oversold.
The Difference Between RSI and Stochastic Oscillator
So, the RSI and the stochastic oscillator might sound fairly similar so far, so what’s the difference?
While they’re both used to figure out momentum, they use different information. The RSI uses volatility as its base of calculation, where the stochastic oscillator uses closing prices.
Additionally, the RSI is usually standard as a stock screening tool. The stochastic oscillator is more likely to need to be done “manually”.
Finally, the numbers can be different. With the stochastic oscillator, below 20 is considered oversold, and above 80 is considered overbought, as opposed to the 30 and 70 with the RSI.
The RSI is a popular indicator with good reason.
It has stood the test of time as a relevant and helpful indicator of trends, and can help support your stock research when deciding to make a trade and working to determine entry and exit points on your trading plan.
However, like all technical indicators, the RSI should never be the sole deciding factor about whether or not you enter a trade. You need to carefully consider the stock’s price action, look at a variety of technical indicators, and perform detailed fundamental research.
It’s by being extremely and painstakingly thorough in your research that you’ll be able to get the biggest picture look at the stock and make the most intelligent trading decisions.
— Tim Sykes
Editor, Penny Stock Millionaires