Relative Strength Index Trading - Generating Reliable Buy Signals With the RSI
By Travis W
The relative strength index is a very simple, but powerful momentum oscillator used by investors who invest in the stock market. Over the years it has proved to be a reliable technical indicator to help traders enter and exit trades. It is often called the relative strength indicator or RSI for short.
In this article we will only focus on the buying side of the trade.
The relative strength index is classified as a momentum oscillator. For this particular momentum oscillator it measures price momentum. Is the momentum increasing in the "up" direction or is the momentum increasing in the "down" direction?
The relative strength index works just like all the other momentum oscillators:
- It indicates whether the market is moving to new highs, new lows, or is just meandering in the middle
- It uses recent price and volume data to aid in assessing whether a recent change in trend will continue or revert to its prior state
- And last but not least, it's used to pin point overbought and oversold signals
The RSI is plotted on a scale ranging from 0 to 100. The magnitude of the stock's recent price movement (gains vs. losses) is compared and then that relationship is translated into a number ranging from 0 to 100.
The center line for the RSI is 50. Above 50 represents bullish territory and below 50 represents bearish territory.
If the number produced is 50, it means that the stock is sitting in the middle. It's trending neither up nor down; it's sitting somewhere in the middle.
The RSI is only reliable if it's used on trending stocks.
Making Money with the Relative Strength Index
There are three conditions you look for before you enter a trade with the RSI:
- Overbought: A technical condition that occurs when there has been a lot of buying and the price of the stock is considered too high and susceptible to a decline.
- Oversold: A technical condition that occurs when there has been a lot of selling and the price of the stock is considered too low and a rally in prices is anticipated.
- Divergence: When the stock price is going in one direction and the technical indicator is going in the opposite direction.
With the RSI, oversold conditions are indicated by values in the 0 to 30 range and overbought conditions are indicated by values in the 70 to 100 range.
Sometimes you'll see traders use 80 and 20 for overbought and oversold signals. I use 70 and 30.
- If the stock has been trending up, but the relative strength indicator starts to trend down, there is a divergence and you would prepare to enter a bearish trade (down direction). It's the vice versa for bullish trades.
- Traders look to establish bullish positions (up direction) when the relative strength indicator dips below or touches the 30 line and then rises back above it.
- Traders look to establish bearish positions (down direction) when the relative strength indicator rises above or touches the 70 line and then falls back below it.
Once the stock becomes overbought, oversold, or has price divergence you should always wait for some type of confirmation that a price reversal has indeed occurred.
Do you want to see proof of how well the relative strength indicator works? If so, I've found one stock in particular that caught my eye. Boeing Inc. had an 85% gain in three months after the RSI triggered for a buy signal.
Now those types of trades don't happen all the time, but they do happen nonetheless. I've illustrated this example on my site to give you a visual example of how the relative strength index works.
Check out the relative strength indicator in action.
Don't miss out on these types of gains again!
The author is chief trader and founder of http://www.learn-stock-options-trading.com Learn-Stock-Options-Trading.com is a free web based options trading course that provides a way for beginners to understand the complex world of options trading.
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