If you had a tool to tell whether a stock's next move would be higher or lower, your investment results would be pretty impressive. If you could easily and quickly check any and all stocks against just such a tool before you traded them, your portfolio might grow rapidly.
The Relative Strength Index (RSI) is used to tell whether a stock's price is reaching a point of reversal. However, like most investing tools it has its limitations, and should not be used by itself as a one-stop, catch-all investment tool.
The Cycle of Shareholding
All shares oscillate between being overbought and oversold. No matter the quality of the underlying company, any stock will go through these predictable cycles, regardless of initial or continuing successes.
The beauty is that you can easily and quickly check any stock in a matter of eight seconds or less, to see if there has been too much buying or selling. What is really important for you to understand is that these conditions almost always reverse themselves—overbought stock prices fall, and oversold share prices rise.
In fact, the market as a whole is trying to return to neutral—a state of being neither overbought nor oversold. In a quest for "normalcy," the market acts somewhat predictably in its journey back to equality of supply and demand.
All Stocks Peak and Decline
For example, if an incredible company (with everything going for them) drives higher prices, investors will stampede into the shares, causing the investment to quickly reach an overbought condition. This causes prices to climb too high for the market to endure, because of buyer resistance to exorbitant prices.
Checking for Overselling or Overbuying
The same holds true (albeit in reverse) for oversold shares. At the other end of the buying spectrum, when prices become high enough that buyers believe the value of the shares will drop, a mass sale of shares ensues.
The stock becomes increasingly oversold as the available supply dries up. Anyone left with shares stops selling since they risk losing large amounts of share value.
While the topic is being incredibly simplified here for the purpose of explanation, the key takeaways are:
- Oversold shares typically rise higher in price within weeks (or months at most)
- Overbought shares typically fall in price
There are several free, online web portals (financial sites) that calculate and display this data for you, in a simple line graph. With three clicks and within eight seconds, you will know exactly how oversold or overbought a stock is, and by extension understand whether it's next move will be a higher or lower price.
Using the Relative Strength Index (RSI)
The RSI is a technical analysis momentum indicator which displays a number from zero to 100. Any level below 30 is oversold, while an RSI of over 70 suggests the shares are overbought.
Thus, if IBM has an RSI of 25, you can assume that the shares are very likely to rise from current levels. There has been too much selling, and anyone disenfranchised with the investment has moved on, leaving mainly new investors, or those with an optimistic outlook for the company.
Conversely, if IBM had an RSI of 70 the shares will typically receive downward pressure from the market. Buyers have stampeded to buy the shares, and share prices will be pushed higher until the market cannot handle the price due to demand.
The Relative Strength Index indicator is like an elastic band. The further it moves towards 100 or 0, the stronger the pull will be in the other direction.
For this reason, you will rarely see an RSI level of over 80. You also will not often encounter an RSI of less than 20.
While it is possible that an extremely overbought or oversold stock will become even more overbought or oversold, such an outcome becomes increasingly unlikely the further to the extremes the RSI reaches. Theoretically, an investor might see excellent trading results by doing nothing other than only buying stocks with an RSI of 20.
Market Resistance and Support
There is almost always an exact moment, or tipping point, where demand suddenly dries up for any overbought stock, and the investment begins to slide. Conversely, there is a point where demand suddenly picks back up, and investment prices rise.
This is basically what the RSI is a measure of. The RSI indicates the resistance and support of a share.
The point at which demand can no longer support high prices is market resistance, where the market pushes the price back down is the point at which there is a high RSI. When demand is strong enough to keep prices from falling further, market support pushes back and keep prices from falling—a low RSI.
Comparisons Between Companies
The most effective way to use the Relative Strength Index is to assist in choosing between high-caliber companies. If you are looking into a couple of excellent stocks, both of which have solid financial situations and excellent management teams, the RSI could help you decide between them.
Mind you, if the difference in the Relative Strength Index values is negligible, such as 25 compared to 30, then the RSI will not provide any insights. However, picture one company with an RSI value of 80, and the other at 30—the former is likely to fall in price in the near term, while the latter is oversold, and due to a reverse of the pricing trend.
All other things being equal, the stock which displays the lowest RSI is one which is the most oversold.
Some Useful Tools
There are a few good financial portals that display the RSI for any stocks you want to check. BigCharts.com is one of the online tools you can use. Type the ticker symbol into the form field (for example, MSFT, IBM, CCL, MCD, etc.). Then click on advanced charts, instead of basic charts.
You can then select "indicators" from the left column, choose RSI for "lower indicator 1," and click "Draw Chart" below it. This should post a trading chart for whichever stock you used, with the RSI values displayed as a line immediately below, across the bottom section.
Identifying Undervalued Opportunities
If you are looking to invest in some undervalued opportunities, looking for stocks with RSI values of 30 or less may be an appropriate starting point.
This is why patience is important as the stock almost always will come back from an oversold situation, and it is important to look at the bigger picture, rather than relying on one single technical analysis indicator on its own.
Remember, there is no (at least, not yet) technical analysis indicator useful by itself. Each tool should be applied along with numerous others, in order to get a larger, clear picture of the future value of a stock.