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RSI Indicator: Evaluate Stocks As Overbought or Oversold

The relative strength index (RSI) is a momentum indicator that evaluates overbought or oversold conditions by measuring the magnitude of recent price changes for various assets. The index was introduced in 1978 by technical analyst J. Welles Wilder Jr. in his book New Concepts in Technical Trading Systems. The RSI is displayed as a line graph that moves between two extremes, which is called an oscillator. Its reading can range from zero to 100.

The primary trend of the stock or asset is used to ensure that the indicator’s readings are properly understood. Well-known market technician Constance Brown widely promoted the idea that an oversold reading on the RSI that occurs in an uptrend is likely much higher than 30% while an overbought reading on the RSI that occurs during a downtrend is much lower than 70%.

Traditional interpretations and usage of the RSI dictate that values of 70 or above suggest that a security becomes overbought or overvalued and may be primed for a trend reversal or corrective price pullback. An RSI reading of 30 or below indicates an oversold or undervalued condition.

Key Takeaways

  • The relative strength index is a momentum indicator that looks at the pace of recent price changes to determine whether a stock is ripe for a rally or a selloff.
  • Market statisticians and traders use the RSI with other technical indicators to identify opportunities to enter or exit a position.
  • When the RSI surpasses the horizontal 30 reference level, it is a bullish sign and when it slides below the horizontal 70 reference level, it is a bearish sign.
  • Divergence occurs when prices move in the opposite direction from an indicator like an oscillator.
  • Failure swings are trend signals that indicate a reversal and can occur during uptrends and downtrends.

Overbought Or Oversold? Using The RSI To Find Out

Overbought and Oversold Levels

Before we dive into using the index, let’s take a look at what it means to be overbought and oversold.

The term overbought refers to an instance when an asset’s trading value is above its fair or intrinsic value. An asset that is overbought tends to be indicative of recent or short-term price movements. As such, there’s an expectation that the market will see a correction in the price in the near term. Assets that are overbought are generally considered suitable for sale.

The definition of oversold depends, though, on who you ask. Fundamental traders believe that an asset is oversold when its price is lower than its fair or intrinsic value. Therefore, they trade lower than their perceived worth. Technical analysts believe oversold assets are those that reach a certain level on a technical indicator, focusing on price and historical data rather than the asset’s value.

When it comes to market analysis and trading signals, the RSI is viewed as a bullish indicator when it moves above the horizontal 30 reference level. Conversely, an RSI that dips below the horizontal 70 reference level is viewed as a bearish indicator. Since some assets are more volatile and move quicker than others, the values of 80 and 20 are also frequently used levels for overbought and oversold assets.

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Investment values start to drop when demand for overbought assets begins to decline.

Divergence in Price and RSI Oscillator

Divergence is a term used by technical analysts to describe signals of prices that move in the opposite direction from a technical indicator. Divergence can be either positive or negative, where positive ones indicate that an asset’s price hits a new low as the indicator’s value climbs. Negative ones, on the other hand, take place when the price hits a new high point while the indicator hits a new low.

In technical analysis, oscillators are used to make high and low banks that exist between two different extremes. They are momentum indicators that can be used with other indicators to pinpoint corrections and price breakouts. This tool then fashions a trend indicator, which rises and falls within these extreme values.

The divergence between the way an asset’s price moves and the RSI oscillator may point to the possibility of a reversal in trends. So when the asset’s price reaches a higher high and the RSI reaches a lower high, the trader can recognize a bearish divergence. A bullish divergence occurs in the opposite scenario.

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Results from the RSI may be misleading when markets are trending so it should only be used during a ranging market.

Failure Swings

Trend signals that indicate a reversal are called failure swings. These swings can take place during uptrends and downtrends, where the former indicates selling activity while the latter represents buying activity. Failure swings occur when the index oscillator doesn’t follow the high point in an uptrend or a low point in the downtrend.

There are two types of failure swings:

  • Failure Swing Top: This type of failure swing occurs when the asset’s price reaches a high point but the relative strength index drops below the most recent fail point (the recent swing low). When this happens, it indicates a signal to sell the asset.
  • Failure Swing Bottom: The failure swing bottom occurs when the asset’s price hits the low point but the RSI jumps above the fail point or the most recent swing high. This indicates a signal to buy the asset.

Failure swings can be very useful for investors who know how to use them. As such, they can be used to trade RSI divergences by identifying recent trends in order to spot the signs of trend reversals.

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RSI Ranges

The RSI tends to remain more static during uptrends than it does during downtrends. This makes sense because the RSI measures gains versus losses. In an uptrend, there are more gains, keeping the RSI at higher levels. In a downtrend, on the other hand, the RSI tends to stay at lower levels.

Image by Sabrina Jiang © Investopedia 2020

During an uptrend, the RSI tends to stay above 30 and should frequently hit 70. During a downtrend, it is rare to see the RSI exceed 70, and the indicator frequently hits 30 or drops under this threshold. These guidelines can help determine trend strength and spot potential reversals.

For example, if the RSI isn’t able to reach 70 on a number of consecutive price swings during an uptrend, but then drops below 30, the trend has weakened and could be reversing lower. 

Image by Sabrina Jiang © Investopedia 2020

The reverse is true for a downtrend. This means that if the downtrend is unable to reach 30 or below and then rallies above 70, that downtrend is said to weaken. As such, it could end up reversing to the upside.

RSI Trendline Breaks

Image by Sabrina Jiang © Investopedia 2020

Momentum Indicators: RSI vs. MACD

Like RSI, the moving average convergence divergence (MACD) is a trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The result of that calculation is the MACD line.

A nine-day EMA of the MACD called the “signal line” is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals. Traders may buy the security when the MACD crosses above its signal line and sell or short the security when the MACD crosses below the signal line.

What Is a Good RSI Indicator?

Traders who are looking for investment opportunities should look for RSI values that hit 30 or fall below that level. This allows them to look for investment options that may be undervalued where the price may increase in the future. But it’s important for investors to remain steadfast and avoid making hasty decisions, since market conditions can change at a moment’s notice.

Is There a Better Indicator Than the RSI?

The RSI measures how quickly the price of an asset moves. It is commonly used when markets are trending. But other trade signals can help traders when overbought and oversold asset prices don’t change course right away. For instance, the moving average convergence divergence and moving average crossovers both allow traders to verify RSI indicators.

What Does It Mean if a Stock Is Overbought?

A stock that is overbought trades at a price above its intrinsic or fair value. This means it doesn’t trade at its true worth. Rather, it’s trading at a price that’s much higher than what it should be.

What Does It Mean if a Stock Is Oversold?

When a stock is oversold, it trades at a price below its intrinsic value. Put simply, it trades at a price that’s much lower than it should. This means that it’s worth much more than the price that it’s trading at in the market.

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