Trading stocks throughout the day is a lot more difficult than buying a stock and holding it for years. Think about it: traders have little room for error and if a trade doesn’t immediately go their way, prudent risk management principles need to be applied. But an investor with a five or 10-year time frame can ride out months or even a few years of poor performance and still exit with a profit.
Fortunately, stock traders have many tools at their disposal to make it just a little bit easier to make a profit. One of the more popular tools used by novice and expert traders alike is the RSI indicator.
What Is RSI?
The Relative Strength Index (RSI) is a momentum indicator that analyzes recent price action to offer either a bullish or bearish signal. The RSI is quantified between zero and 100 and measures if a stock is overbought or oversold.
The math behind the calculation is quite complex but most, if not all trading platforms or chart providers will include RSI and other tools as a default option. The only thing traders need to take away from the math is that an RSI north of 70 implies a stock is overbought. By contrast, an RSI south of 30 implies oversold conditions.
The RSI strategy is based on the thesis that oversold stocks should rise in price when they reach oversold territory. Traders could either buy the stock at this point or cover the trade and lock in profits if they are short the stock.
Similarly, a stock entering overbought conditions is expected to fall in price. investors that already hold the stock may want to hit the sell button and lock in profits. Or, this might be a good level to initiate a short position on a stock that is expected to decline.
Why Traders Love RSI
The beauty of using the RSI indicator is that it is always available for every stock and constantly changes.
In the vast majority of cases, 14 periods are used to calculate the RSI value. The RSI will increase in value when the number and size of prior positive prices increase and will fall when the number and size of prior losses increase.
At the most basic level, one of the many new traders to the market can set a scanner to easily identify when a stock hits an RSI of 30 or 70 and then evaluate the worthiness of a trade. This isn’t an oversimplified representation of the RSI indicator, rather it is in fact a great starting point for many traders.
The wait-and-see RSI strategy emphasizes discipline in trading as it forces a trader to wait for a trade that is statistically more likely to end up in their favor.
Conclusion: Not A Foolproof Indicator
An overbought stock has one of two potential outcomes. It will go against RSI principles and become even more overbought or it will fall in price. Which of these two outcomes will happen can never be predicted in advance.
In other words, a stock with an RSI of 30 could continue to fall or even crash while a stock with an RSI of 70 could soar to new highs and defy the odds.
While traders following many stocks will likely see this play out on a daily basis, it is at the end of the day statistically uncommon. Typically, an RSI level rarely exceeds 80 nor does it often come in below 20.
Savvy traders understand this reality and could spread out the dollar amount they want to put into a trade. For example, a trader that wants to buy $5,000 worth of XYZ will first buy $2,500 worth of shares when the RSI level reaches 30. If the stock falls and the RSI now measures 20, the trader will allocate the remaining $2,500.
In this scenario, if the stock quickly rebounds off an RSI of 30, the trader will still lock in a profit and move on to identify the next opportunity.