Unlocking the Power Of The Relative Strength Indicator

Trading financial instruments is a constant process of speculation. Knowing the right time to buy or sell an instrument can greatly aid in ensuring that you rake in profits from trading. This can be done through the use of tools that aid in predicting the future movement of the price of a stock. 

The RSI indicator measures the momentum in the price movement. This means how strong the stock is moving up or down. A strong movement in a particular direction may indicate a likely future trend but it may also show when a stock is overbought or oversold. The RSI's ability to give multiple signals with high accuracy in predicting future prices is why it is one of the most powerful indicators available to traders.

The Basics Of The RSI Indicator

To measure momentum, technical traders use RSI as a key indicator. RSI stands for Relative Strength Index and is represented as a value in the range between 0 to 100. Values above 50 show that an upward movement is likely to occur, while values below 50 indicate a downward momentum. The further the distance from 50 the stronger the momentum in either direction. Values above 70 or below 30 show that the momentum is so strong indicating that the market is oversold or overbought. Often in extreme conditions, the price will move in the opposite directions briefly to alleviate the oversold/overbought condition

Look at the example below, which shows Tesla ($TSLA), where the price bounced when the RSI was oversold, followed by a pullback when RSI was severely overbought. Notice, as priced moved in the opposite direction due to the overbought/sold conditions the stock went back to its original direction (up). This is simply just another reminder that stock trading is just as much science as art.


tsla tesla stock chart example rsi overbought oversold

RSI is measured through how often the market closes up vs closing down and by what margin. It is calculated through the use of two relatively simple formulas:

                    100
RSI = 100 - ---------
                    1 + RS

RS = Average Gain / Average Loss

Therefore, the relative strength is measured by taking the average size of all the up moves over a particular period divided by the average size of all the down moves over the same time.


How To Unlock The Power Of The RSI

One powerful indication of a price reversal is RSI divergence. Using RSI in terms of catching divergence makes the indicator one of the most popular and profitable indicators out there. It occurs when RSI does not confirm higher highs or lower lows. For example, the price has made a new low but RSI has not. The chart below shows RSI divergence and how it can signal a selling opportunity (beware of using it to short stocks). Using the RSI indicator for identifying divergence is one of the most powerful technical tools out there. Being able to identify divergence when a stock has made a lower low but the RSI did not; thus foreshadow a reversal can be used for a great buy entry.

I do not recommend using divergence as a tool for shorting, you would have to be really skilled and would need additional technical signals to even make this profitable.

Moderna MRNA negative divergence example RSI

Conclusion

As you can see from this article, the RSI has several powerful methods of signaling future price action. The first way is once the indicator is overbought or oversold, you will likely see a price reversal. The second way is with price divergence whether the price does not agree with the RSI. My favorite usage of the RSI is when price makes a lower low but RSI does not, which usually foreshadows a wicked bounce.

Lastly, I highly recommend against using the RSI to short stocks, that is a dangerous game. Ideally, you would use the RSI indicator to try to sell the high and buy the low. Whether this buys using the overbought/oversold signals or divergence. It's up to the reader to understand the nuances to maximize the profitability of this indicator through backtesting and watching the RSI in real-time, as stocks trade.

If you are interested in learning more about technical indicators take a look at The Art Of Mastering Japanese Candlesticks as well as my favorite two stock chart technical indicators.

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