Relative Strength Index
The Relative Strength Index (or RSI) is an oscillator tool that is well known, commonly used and widely respected. The term "Relative Strength Index" is somewhat misleading, because it doesn't actually compare the "relative" strength between two stocks as you might think it would. Instead it measures the internal strength of just one. They should have just named it the "Internal Strength Index."
The RSI is an oscillator that follows price, and ranges between 0 and 100. A common way of trading the RSI is by looking for a divergence where a stock is creating a higher high, but the RSI is falling to lower lows or even staying flat. This divergence is a signal that a reversal is imminent.
When the RSI then turns down and falls below its most recent high, it is said to have completed a "failure swing." The failure swing is considered a confirmation of the impending reversal. A display is below to explain further.
Parameters
The typical default time frame for RSI is 14 candles. However, this can either be lowered to increase the sensitivity to price change, or raised to decrease sensitivity. RSI for a 10 day is more likely to hit overbought or oversold than RSI for a 20 day. The displayed time frame should also be based on the stock's volatility. For example, a 14-day RSI for a big name internet retailer like Amazon (AMZN) is much more likely to become overbought or oversold than 14-day RSI for Duke Energy (DUK), which is a small name utility.
RSI by default is overbought when it reaches levels of 70 or above and oversold when it reaches 30 or below. These traditional parameters can also be customized to better fit the stock or analytical requirements. Increasing the overbought level to 80 and/or decreasing the oversold level to 20 will reduce the overall amount of overbought or oversold indications.
Overbought and Oversold
As previously mentioned, RSI is considered to be overbought anywhere above 70, and to be oversold anywhere below 30. The chart below shows a 14-day RSI for GMCR. Moving from left to right, the stock became overbought in August 2014 and finds support around 129. Notice that the dips evolve after the oversold readings, and not as soon as the oversold readings appear. However, 5 more overbought readings are indicated before the stock finally reached it's peak in November. Momentum oscillators can become overbought (or oversold) and remain that way in a strong up (or down) trend, as shown during a major sell off beginning in May of 2015.
Similar to some other momentum oscillators, overbought and oversold readings for RSI tend to be most reliable when price action is moving sideways within a range.
An indication to buy is created when the RSI crosses the oversold line in an upward direction, meaning that it crosses from below the oversold line to the upside. An indication to sell is created when the RSI crosses the overbought line in a downward direction, meaning that is crosses from above the overbought line to the downside. In personal experience, I've found these indications to be more accurate after changing overbought and oversold levels to 80 and 20. Below are examples of both a 70/30 and an 80/20 chart with buy and sell signals.
Now set on 80/20.
Another considerable crossover technique is using the centerline (or the 50 mark). The technique is executed the same way as using the overbought and oversold lines to form signals. The centerline crossover is used as more of a confirmation then a buy or sell signal compared to the other techniques. A downward trend is confirmed when the RSI crosses from above 50 to the downside. An upward trend is confirmed when the RSI crosses above 50 to the upside.
Divergences
Divergences indicate a potential reversal point due to the momentum not matching the price action. Bullish divergences occur when the stock price makes a lower low, yet the RSI makes a higher low. RSI doesn't match the lower low which indicates that momentum is getting stronger.
Bearish divergences are just the opposite, and occur when the stock makes a higher high while the RSI makes a lower high. The RSI doesn't match the new high which indicates momentum is slowing. The chart below is a great example. It shows VLTC and it's epic run from $1 to over $21 in a matter of days. As you can see, the RSI is obviously overbought for the majority of the rally. However, you will notice "bearish divergence #1," as the price sees a substantial increase, but the RSI stays flat. Again, RSI not confirming price on the chart. "Bearish divergence #2" is even higher in price, but substantially lower in RSI. The divergence was a signal to sell on its own, but coupled with a bearish cross of the overbought line to the downside, created a huge red flag to sell or short the stock. The longs that caught this signal sold their shares, while shorts opened new positions, leading to the sharp sell off shortly after. A long fade follows, as the RSI continues to decline.
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Now before you get too excited about divergences as amazing trade signals, you should note that divergences can really mislead you in a strong trend. A stronger downtrend might show several bullish divergences before it actually bottoms. On the flip side, a strong uptrend can show several bearish divergences before we see a top. Read Trading Market Bottoms and Tops to learn more about catching some of these moves.
AAPL is a great example of this, and a reason to use caution in strong trends. As you will see from the chart below, AAPL had at least 18 bearish sell signals JUST on the RSI from it's run to 133.
Again, you will receive far less indications if you change parameters to 80/20. Another look at AAPL with chart adjusted to 80/20. Far less indications, and based on price action, more reliable signals.
RSI tends to move between 40 and 90 in a bullish uptrend with the 40-50 zone acting as support. The range may vary based on your RSI parameters, the volatility of the stock, and the overall strength of the trend. Again, looking at AAPL below, you can see that the RSI remains above 40 for most of the trend, with 40 acting as support in some situations.
In a bearish downtrend RSI tends to move between 10 and 60, with the 50-60 zone acting as resistance. BBRY is provided in a chart below as an example.
Conclusion
The key to trading the RSI successfully is recognizing failure swing points and crosses of the 50. To put it plainly, a lot of traders see a failure swing as confirmation of a reversal. Many technicians will look at a move above 50 as a representation of average gains surpassing average losses, therefore providing a bullish sentiment in the stock. On the contrary, a level below 50 indicates a bearish market as average losses have overtaken average gains.
In the future, as you look very closely at the relative strength index, make sure you recognize the failure-swing points and confirm the potential breakout. And next time you're trading with RSI on your chart, remember to "stay in your Trader Mentality."
Labels: Technical Analysis
