Why RSI Matters to You
Technical indicators are some of the handiest tools in a trader’s repertoire. But why exactly, and which ones should you use?
As for why … by using different indicators on stock charts and combining it with your careful fundamental analysis, you can get a better snapshot of the stock in question, allowing you to make a more deliberate and intelligent trading plan.
As for which ones you should be using … ultimately that’s up to you, but it’s important to educate yourself on some of the big ones so that you can make that determination.
Today I’ll offer up an introduction to a super popular indicator: the relative strength index.
In the next two issues, I’ll explain what the relative strength index is, why it matters, and how traders use it as part of their technical analysis.
In gaining a better understanding of an important indicator like this, you’ll be better able to make good use of the information it offers.
What is the Relative Strength Index?
Most frequently referred to as the “RSI” in the trading sphere, the relative strength index 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, meaning that it will change based on the most recent price action of a stock.
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.
Trading the Relative Strength Index
Now that you understand the basics, how is the RSI calculated and how do you actually use it? Let’s explore.
How to Calculate RSI
The good news is that you don’t need to know how to calculate the RSI, because most stock screeners will do it for you automatically.
However, it can be helpful to get an overview of how it’s calculated just so that you understand it a little bit more. So, let’s go into it, but don’t worry about memorizing it!
The basic equation used is this:
RSI = 100 – 100/1+RS
The RS from that equation is calculated like so:
RS = Average Gain / Average Loss
Tips on Using RSI
To make the most of RSI in your trading, keep these things in mind:
Overbought Versus Oversold: What’s the Difference?
To make the best use of the RSI, first take a few minutes to educate yourself on the meaning of overbought versus oversold.
They’re pretty much what they sound like, but just for a little infusion through repetition, here’s the definition of each term:
Overbought: This term refers to a time period where there’s been a consistent upward trajectory with a stock, without many pullbacks. Put simply, the stock’s price is rising without too many dips.
While on the one level this is exciting, it falls under the age-old wisdom of “what goes up must come down.” It’s not common for a stock to maintain this sort of action for too long without experiencing a correction or falling eventually.
Oversold: This term refers to a time period with a consistent downward trajectory in a stock’s price, without many upward jumps. Basically, it’s the opposite of overbought. Sure, some stocks will just continue into oblivion, but based on your research, you might determine that there’s room for it to grow.
Generally, with the RSI, a number of below 30 is considered oversold and over 70 is considered overbought, where the range of 30-70 is neutral or no trend.
However, this isn’t always the absolute gospel. Some traders might consider expanding or tightening the parameters based on their style and trading experience.
Make notes of the RSI in your trading journal and over time you can get a handle on what ranges work for you.
There are a few more things I want to go over with regard to RSI. Let’s take a break for now and start back up again tomorrow.
— Tim Sykes
Editor, Penny Stock Millionaires