Trading Stocks Using The Rsi Indicator
The RSI (short for Relative Strength Index) is a popular technical indicator with traders and investors because it is quite effective at showing overbought and oversold positions in a particular security. But how effective is it in reality and can it really be relied upon to trade stocks with any accuracy?
Well as with any technical indicator it should not really be used in isolation because it is only one indicator, but on the whole the RSI indicator is quite effective at indicating both overvalued and undervalued stock positions. There are, however, times when it is more effective than others.
For example, from an investment point of view an RSI that is indicating an overbought position, ie over the 70 level, doesn’t really mean too much when a share is strongly trending upwards because it could easily pull back slightly before accelerating even further ahead and becoming even more overbought. However an oversold RSI, ie below 30, on a bullish share that’s trending strongly upwards often acts as an excellent entry point.
Similarly when a stock is trending downwards you should be very careful about oversold RSI signals because just look at the recent market and you will see that prices have dropped substantially despite all the oversold RSI signals we saw on the way down. In a bearish market it’s a better strategy to look for overbought positions in weak stocks that are in a strong downwards trend and take short positions.
Overall I think RSI is a very useful technical indicator in general but it can be rendered useless in the face of a strong trend. If you are looking to catch the bottom of a stock you’re interested in buying that’s in a strong downwards trend, your best bet is probably to consult the longer term weekly or monthly charts. That’s because if the RSI is oversold on these time frames, then it’s a better more reliable signal than an oversold position on the daily charts. It also provides a better entry point for anyone looking to invest in a company for the long-term rather than a few weeks or months.
Of course you should also look at the fundamentals of the company in question as well including the financial accounts and earnings forecasts, PE ratios, etc, because you may find the RSI is oversold because the company is going bust so the price will fall even further. However once you’ve identified a good quality profit-enhancing company, the RSI can provide you with a strong entry point when in oversold territory, particularly if the stock is in an upwards trend.