Strength – It’s All Relative
Hello, everyone. Welcome back to the classroom. It’s a pleasure to deliver this weekly lesson to you today. Today, we are going to take a look at the Relative Strength Index (RSI): what it does, how to use it, its limitations, and more. Let’s begin.
What is the Relative Strength Index (RSI)?
Simply put, the RSI is a measure of how overbought or oversold a stock is at a certain point. While there is a considerable amount of math behind it, you don’t need to worry about the complexities, as the RSI is calculated for you by any standard charting service. However, for those interested in the detailed calculations, here’s a page that goes into the specifics.
The RSI measures recent price changes and moves between 0 and 100, providing short-term buy and sell signals. Typically, an RSI below 30 indicates that a stock is “oversold,” while an RSI above 70 means the stock is “overbought.” This is important to understand.
If you’re thinking, “This sounds similar to technical analysis,” you are correct. While I’m not the biggest fan of technical analysis, as it often involves a lot of subjective interpretations, there are instances where basic principles can be very helpful.
How to Use the RSI
When considering selling a stock, an RSI of 70 suggests it may be a good time to sell, as the stock is overbought. Conversely, an RSI of 30 suggests it might be better to hold on, as the stock is oversold and likely to rise.
Here’s an example using BP’s closing share prices from January to May of 2011 to illustrate this concept.
Limitations of the RSI
Like most tips we provide, the RSI is not a foolproof method for picking winning stocks. Similar to other technical indicators, it should not be relied upon exclusively. Since the RSI measures momentum, it can remain in the overbought or oversold zone for an extended period when an asset has strong momentum in either direction. Therefore, an RSI of 30 does not guarantee an immediate increase in stock price.
However, the RSI can often provide insights into the next direction of the share price with greater accuracy than many other signals. The RSI is particularly effective in a ranging market (where prices move back and forth between a high and low price level), rather than in a trending market (where the stock is overbought, but the price continues to rise as people buy into the trend).
Conclusion
That’s all for today. This was a quick overview of how to use the Relative Strength Index (RSI). It’s a handy tool I like to use when conducting my due diligence on a stock, and it’s easy to pull up and find. Have a nice day!
Disclaimer: This is not financial advice.
