This Indicator Helps Spot Major Market Moves Before They Happen
The Relative Strength Index (RSI) is among the most popular technical indicators. Developed by J. Welles Wilder and featured in his 1978 book New Concepts in Technical Trading Systems, RSI is a price oscillator that helps traders identify oversold and overbought markets.
Despite being called the Relative Strength Index, RSI does not provide any information on relative performance or relative strength. The formula uses data only from the stock, mutual fund, ETF or other investment being analyzed. Relative strength, on the other hand, compares the investment being studied to other available investments.
The RSI indicator is calculated using the following formula:
RSI = 100 – [100 / (1 + RS*)]
*Where RS = Average gain / Average loss
The default time frame used to calculate the averages is 14 days, but this can be modified depending on your needs.
How Traders Use Relative Strength Index
Traders use the Relative Strength Index to spot oversold market conditions when RSI falls below 30 and overbought market extremes when RSI is above 70. The conditions for “overbought” and “oversold” can also be tweaked. For example, a trader may want fewer “overbought” and “oversold” signals for a security, so changing the conditions to 80 for “overbought” and 20 for “oversold” may be more suitable.
Markets can remain oversold or overbought for extended periods of time. So it is usually best to wait for the indicator to reverse before entering a position. You can see how this would have paid off in the example below.
As you can see in the chart, RSI would have proven useful as a signal to get out before the Covid-19 selloff in March 2020. The same goes for when the Nasdaq dipped 13% in September. However, RSI only briefly dipped below the buy signal of 30 in March. This highlights why it would be wise to rely on other indicators in conjunction with RSI.
While many traders look at the 14-day RSI, short-term traders often use the 2-day RSI. With this time frame, the overbought level could be as high as 95 and oversold markets will have an RSI reading below 5.
Short-term traders will buy or sell when the 2-day RSI hits those extremes rather than waiting for a reversal, and exit the trade based on a predefined holding period. This is a very aggressive strategy, but it can be successfully implemented by short-term traders.
Traders also use RSI to spot divergences. If the price reaches a new high while this technical indicator is moving lower, that is a sign of a possible price reversal.
Why Relative Strength Index Matters To Traders
When a technical indicator is popular, it can move markets in the short term. If a large number of traders spot a divergence or an overbought/oversold signal in the RSI, a quick price move could follow.
RSI is a highly reliable technical indicator. It usually delivers tradable results in backtesting with daily, weekly, and monthly data on stocks, ETFs, and stock market indexes. By monitoring RSI, traders can increase their odds of being on the right side of major market moves.
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