Getting the Most From Relative Strength Index (RSI)
The Relative Strength Index (or RSI) is an oscillator tool that is well known and widely respected. The term “Relative Strength Index” is somewhat misleading. It doesn’t actually compare the relative strength of the stock to an index as you might think it would. Instead, it measures the internal strength of just one you’re viewing.
They should have just named it the “Internal Strength Index.”
The Relative Strength Index follows price and ranges between 0 and 100. A common way of trading the RSI is by looking for a divergence. This is where a stock is creating a higher high, but the RSI is falling to lower lows or staying flat. This divergence is a signal that a reversal may soon occur.
Most trading platforms and charting software have RSI available as an indicator. TradingView has it listed as RSI, but many other platforms may have it spelled out as Relative Strength Index. They are the same.
Relative Strength Index Parameters
The default time frame for the relative strength index is 14 candles. However, you can lower it to increase the sensitivity to price change or raise it 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 a 14-day RSI for Duke Energy (DUK) which is a small name utility.
Relative Strength Index (RSI), by default, is overbought when it reaches 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 signals.
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 occur before the stock finally reaches 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.
Buy and Sell Signals
A signal to buy occurs when the RSI crosses the oversold line in an upward direction, meaning that it crosses from below the oversold line to the upside. A signal to sell occurs when the RSI crosses the overbought line in a downward direction, meaning that it 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 look at it set on 80/20.
Relative Strength Index Divergences
The chart below is a great example. Its VLTC 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 is not confirming the 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.
Not So Fast
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.
AAPL is a great example of this, and a reason to use caution in strong trends. As you can see from the chart, AAPL shows at least 18 bearish sell signals just on the RSI from it’s run to 133.
Again, you will receive far fewer signals if you change parameters to 80/20. Another look at AAPL with chart adjusted to 80/20. Far fewer signals, 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 stock’s volatility, 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 the chart below as an example.
The key to trading the Relative Strength Index successfully is recognizing failure swing points and crosses of the 50. To put it plainly, many 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.