Identifying Trend Reversals With RSI

Over the course of a stock's trading history, there are times when investors are either too bearish or too bullish, at least in light of the fundamentals. But knowing when these attitudes might lead to a trend reversal isn't always obvious.

Enter the relative strength index (RSI), which measures momentum, or the degree and speed of price movements. This technical analysis tool can help identify when a stock is potentially overbought or oversold.

Here's how the RSI works; how it can help you identify potential trade signals, or buy and sell opportunities; and what to consider before adding the RSI to your trading toolbox.

The RSI tracks the strength of a security's price against its own history—its average gains divided by its average losses—over a specific period of time. A stock's RSI typically looks at the most recent 14 trading days, though you can shorten the time frame to generate more trading signals or extend it to produce fewer but possibly more reliable signals.

When it comes to a security's RSI reading—on a scale from 1 to 100—there are two numbers to watch:

• When a stock's RSI moves above 70, it's generally considered to be overbought—and traders may see an exit opportunity when it crosses back below 70.
• When a stock's RSI moves below 30, it's generally considered to be oversold, providing traders an entry opportunity when it crosses back above 30.

When a stock's RSI diverges from its price, a trend reversal may be afoot.

For example, you would expect a stock in an uptrend to exhibit higher highs in its RSI readings as investor enthusiasm builds. However, when a stock registers a higher high in price but a lower high in its RSI, it could signal slowing momentum and an impending reversal.

Conversely, when a stock registers a lower low in price but a higher low in the RSI, the downtrend may be about to reverse.

One of the main risks of using the RSI is that a stock can sustain an uptrend or a downtrend for an inordinately long period. In such cases, you might need to adjust your RSI levels higher or lower than the standard 70 and 30.

As with any indicator, the RSI is far from infallible. For example, because it typically uses the past 14 days of price data, it may not reflect more immediate economic news, earnings, or other sudden forces that can affect a stock's price. Therefore, consider the following steps as you familiarize yourself with this trading tool:

• Wait for the comeback: To avoid situations where an overbought or oversold stock becomes even more so, you may want to hold off trading as soon as a stock reaches an RSI threshold and instead wait until it crosses in the opposite direction—especially if it's been known to operate in a narrower range or regularly defy typical RSI behaviors. For example, if you note that a stock's RSI is currently below 30, you might consider waiting until the RSI moves back above 30 before buying the stock.
• Scale in and out: Start with a quarter or a third of your usual trading position and add to it in increments if the stock moves as you anticipate. For example, if the RSI crosses above 30, you might start by buying a percentage (say 25% or 33%) of your usual position size and then adding to the position if the stock price is confirming a rebound. That way, if the stock gives a false read or doesn't move as anticipated, you can exit your position at a relatively smaller loss.
• Look for other confirming signals: In addition to the RSI, moving averages—which help identify a stock's price trend over time—can identify support and resistance levels that, once broken, can indicate a trend is reversing. Similarly, price moves accompanied by higher-than-average trading volumes can confirm strength, while those that correspond with weak volume may lack conviction and generate a false signal.

Using the RSI to identify trade signals can feel a bit like reading tea leaves at the start. But the longer you study a specific stock's RSI movements, the more proficient you'll become at noticing patterns and potential trade opportunities.