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Investors use the indicator of relative strength index, or RSI for short, to gauge a security’s momentum. This indicator is a key component of technical analysis that helps day/swing traders understand if a stock is “overbought” or “oversold.”
Let’s take a closer look at what RSI is, how the indicator is used, and why it is helpful for traders.
What Is Relative Strength Index (RSI)
RSI is a momentum indicator that helps investors gauge whether a stock or equity is oversold or overbought. RSI is represented numerically and displayed as an oscillator, between the values of 0-100.
What Does RSI Tell You?
As notated above, the relative strength index helps investors determine if a stock is overbought or oversold. Originally created by J. Welles Wilder Jr., the nuances of the RSI indicator were detailed in his late 70s book called New Concepts in Technical Trading Systems.
The most important information revealed by the RSI metric is whether the stock or other asset in question is becoming overvalued or overbought or has already reached the status of being overvalued/overbought.
If the stock is overvalued, it might be on the cusp of a significant pullback. Alternatively, if the stock is oversold, there is the potential for a rapid return to a more reasonable trading price.
How RSI Works
A stock with an RSI of 70 or higher is considered overbought, whereas a stock with an RSI of 30 or less is considered oversold.
However, if a certain stock reaches the overbought level repeatedly, some investors will adjust the RSI level to 80 or higher. These calculated adjustments help day traders time trades.
Savvy investors will continue to adjust the RSI benchmarks to fit the specific security in question. It is important to note that when there are particularly strong market trends, the RSI might end up oversold or overbought for an extended period.
When there is an uptrend, meaning a bull market, RSI is typically between 40 and 90, with 40 to 50 zone serving as support.
If there is a bear market or a downward trend, the RSI will likely be between 10 and 60. If the underlying price reaches a new low or high that the RSI does not confirm, the divergence indicates a price reversal.
In the context of RSI, Bottom Swing Failures are when the indicator hits a higher low followed by an upward move beyond a prior high.
Top Swing Failures are when the RSI achieves a lower high then moves downward, below its prior low.
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Is RSI a Good Indicator?
Relative Strength Index is one of the most widely used indicators by traders and investors. It is easy to use and understand. It helps investors understand whether a stock or asset is oversold or overbought. It is a momentum indicator that helps identify potential price reversals.
Example of Relative Strength Index
When the RSI is 70% or higher, the asset is considered overbought. Alternatively, if the RSI is below 30%, it is oversold. Remember, the relative strength index helps investors understand bullish and bearish price movements.
RSI is not easy to calculate. Below is the formula to calculate RSI:
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ) ) ]
>> Learn More: A Beginners Guide to Researching Stocks
What Is a Good RSI to Buy?
If the RSI of a stock is 30 or less, investors view this is a strong buy signal.
The logic in this strategy is that the RSI indicates the security in question has been egregiously oversold, meaning there will be a “dead cat bounce” in the near feature.
However, it is important to note, that RSI is not the only indicator investors should rely on. It is merely just one tool in your arsenal as you analyze various stocks.
What Is a Good RSI to Sell?
If the RSI number is 70% or higher, it is a sign that too many investors have jumped on board, and now might be the optimal time to sell.
Should Beginner Investors Use RSI as an Indicator?
Investors of all experience levels can benefit from the use of RSI as a component of technical analysis. However, RSI alone should not determine whether a beginner investor decides to purchase or sell a stock.
The RSI is only one piece of the stock’s puzzle. Consider the RSI indicator in addition to other analytical components when breaking down a stock for potential investment.
Is it Safe to Use RSI as an Indicator in Technical Analysis?
Yes. RSI is a safe indicator to use in technical analysis. It is used by hedge funds, institutional investors, and individual day traders regularly. In fact, it might be the first indicator most active investors review before they make an investment decision.
Bottom Line: What Is RSI?
Whether you are an experienced technical trader or a newbie retail investor, you will benefit from the use of the RSI indicator.
Though this indicator does not have to shape your investing decisions completely, it will certainly provide valuable insight that helps you make prudent choices with your hard-earned investing dollars.