Trading Up-Close: Relative Strength Index

The Relative Strength Index, or RSI, is a technical indicator measuring the strength and momentum behind a stock's recent price moves. It can give you a sense of when a stock might have become over- or undervalued—and possibly ripe for a reversal. RSI measures how much a stock has gained on its up days relative to how much it’s lost on its down days, over a default of 14 trading periods.

On a price chart, a stock’s RSI is plotted as a single line, oscillating within a fixed range between 0 and 100. Generally, when a stock has an RSI reading above 70, it is considered to be overbought and perhaps due for a retreat from recent highs. On the other hand, a reading below 30 suggests the stock may be oversold and could be ready to move higher. As you can see in this example, when the RSI moves near 70, the price tends to weaken afterward. And when the RSI comes down near 30, the price tends to rally. Now, it’s important to note that these 70 and 30 readings work best when a stock is neutral, as shown here.

However, when a stock is in an uptrend or a downtrend, these levels might not be as reliable because of the buying or selling driving this current trend. In a strong uptrend, for example, a stock’s RSI might stay above 70 for longer than it would in neutral conditions as traders’ enthusiasm for the stock drives its price higher. When this happens, a drop from above 70 to below 70 could indicate that the stock is taking a breather on its long push higher.

Conversely, when looking at oversold conditions within a strong uptrend, the RSI is unlikely to fall to this classically oversold level of 30. Notice how in this chart, temporary dips below the 50 line are followed by a continuation of the overall uptrend in price. Traders may want to allow the RSI to recapture its 50 line before joining the uptrend.

As you might expect, this can also work for downtrends, when a stock’s RSI might spend more time below 30 than it would in neutral conditions. In this case, you could use temporary peaks above the 50 line as a signal that the stock is taking a breather from its downtrend. Dropping back below its 50 level could indicate the downtrend is set to continue.

Another way to use RSI is to look for divergences from price moves, indicating possible weakness in the current trend.  It may also signal an impending reversal of the existing trend. Here we see that the RSI dips as the stock hits a low. Notice how the first dip in the RSI is much lower than the second one, despite the stock’s price actually hitting a lower low.

A technical trader might look at this lower low in the stock price and see a continuation of the downtrend. However, the divergence between the sharply falling stock price and the modest dip in the RSI could signal that the downtrend has weakened and higher prices may be in the offing.

The RSI can be a helpful technical indicator but it’s important to understand its movements in all conditions.  To learn more about technical analysis and its practical uses, watch more videos in this series and subscribe to our YouTube channel.