Know When to Buy or Sell Any Stock

Using the Relative Strength Index Reveals When to Trade

Clear Piggy Bank on Desk
Clear Piggy Bank on Table. Jonathan Kitchen

If you knew 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 an online tool before you traded them, your portfolio would grow quickly. And if you wanted to see exactly how and why this works, you would probably want to keep reading.

All shares oscillate between overbought and oversold conditions.

No matter the quality of the underlying company, any stock will go through predictable cycles, regardless of their final destination.

The beauty is that you can easily and quickly check any stock in a matter of 8 seconds or less, to see if there has been too much buying or too much selling. What is really important for you is that these conditions almost always reverse themselves - overbought stocks fall, oversold shares rise.

In fact, every single investment out there is trying to return to neutral - a state of being neither overbought nor oversold. In their quest for "normalcy," the shares act predictably in their journey back to established norms.

For example, if an incredible company (with everything going for them) drives higher in price, as investors stampede into the shares, the investment will quickly reach an overbought condition. Even the most amazing stocks eventually reach their peak, and they will decline.

This is usually in line with an overbought condition - too many people have purchased shares. Typically, once everyone who has wanted to buy has done so, the sudden decrease in demand leaves a void into which the shares fall.

The same holds true (albeit in reverse) for oversold shares. When anyone who wants out of a stock has dumped their holdings, the conditions become increasing oversold as the available supply dries up (since there are fewer shareholders looking to sell).

Even the slightest amount of buying at that point can result in the share price getting pushed to much higher levels.

While the topic is being incredibly simplified here for our purposes, just know that:

  • Oversold shares typically move higher with weeks (or months at most)
  • Overbought shares typically fall in price
  • You can easily and quickly check the situation for any stock 

There are several free, online web portals (financial sites) which calculate and display all this data for you, in a simple line graph.  With 3 clicks and 8 seconds, you will know exactly how oversold or overbought your shares are, and by extension have clarity about whether the next move in the stock's price will be higher or lower.

This all revolves around 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.

At the same time, if IBM had an RSI of 70, or even as high as something dramatic like 85, then the shares are typically in for downward pressure. Buyers have stampeded over other buyers, and shares will be pushed higher, until... they aren't. 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.

It may help to think of it like supply and demand of a retail product. Whatever the latest fad might be, whether it is Cabbage Patch dolls, Swatch watches, Beanie Babies, or whatever, people will typically buy like crazy at first. The manufacturers of that product run their machines or assembly lines overtime to meet the demand. 

Then the product reaches a point where just about everyone has one (or several).

This can be likened to an overbought situation in a stock.

The producers are still pumping out the widgets like mad to meet the demand, but when that overbought condition is reached, the buying dries up. The product now shifts to a glut, where there are too many of the once-hot product available.  

Retailers typically need to drastically drop their prices, just to clear out some of their inventory overhang. Eventually, the deep discounts, combined with the production machines being slowed or put on pause, shrinks the inventory glut.

If the new supply for the product is significantly curtailed, but there is still some moderate demand, this could be likened to an oversold condition.

Nothing is certain in the stock market, but using the Relative Strength Index is one of the most reliable technical analysis indicators you will ever find. The prices of shares and the activity of the RSI are closely linked and typically trade in nearly identical fashion.

When the RSI slides, the shares have usually already begun their own fall, or if not, they will do so shortly. On the other side of the coin, when the RSI is trending strongly higher, so too will the share price (in most cases).

You don't need to understand how an engine works in order to be able to drive a car. Likewise, rest assured that you can benefit from the Relative Strength Index simply by knowing that oversold shares almost always climb, and overbought shares almost always fall.

As mentioned, there are a few good financial portals which display the RSI for any stocks you want to check. For now, let's just use BigCharts.com, for demonstration purposes.

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.

If you see that the Relative Strength Index line is at 85 for the company you entered, you can be fairly certain that the shares are going to head lower in the short term. At very least, you will know that the particular company is highly overbought.

On the other hand, what if you find an RSI value of only 25 or so, for the company you are checking. Well, I don't know what specific stock you chose to look into, but, in this case, I can tell you that the shares are heavily oversold, and in almost any situation will see buying demand rise while selling supply dries up.

Remember, every stock is trying to return to the RSI baseline level of 50. Ostensibly, overbought stocks are due for selling, until the shares return to that middle ground. Oversold stocks should expect increased buying until the RSI starts moving back to the RSI level of 50 (which is neither overbought or oversold).

Of course, when overbought conditions start heading back towards that neutral level, they almost always overshoot and dive into oversold territory. Meanwhile, oversold shares often over-correct, and push well into overbought territory.

The Relative Strength Index indicator is like an elastic band. The further it moves towards 100 or 0, the stronger the pull in the other direction.

For this reason, you will rarely see an RSI level of over 80, and even less commonly anything above 85. You also will not often encounter a very low relative strength, such as anything 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.

Of course, no technical analysis indicator is meant to be used in a vacuum. Rather, each tool should be applied along with numerous others, in order to get a larger, clear picture of the future value of a stock.  

However, if there was one technical analysis tool which could potentially be used on its own, it very well may be the RSI. No single tool is fool-safe, or completely reliable every time, but the RSI is much more trustworthy than almost all other indicators which are commonly used.

The most effective way to use the Relative Strength Index, in my opinion, is to assist in choosing between high-calibre companies. If you are looking into a couple absolutely 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 truly will not provide any great 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 reverse higher.

While I do not give trading advice, I will suggest some potential strategies for benefiting from the Relative Strength Index.  

Comparisons Between Companies:

As I mentioned earlier, when you are looking at two (or maybe even three or five or eight...) companies, the RSI may help you decide between them.  All other things being equal, the stock which displays the lowest RSI is one of the groups which is the most oversold.

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.

Understanding Price Activity:

Often you may not understand why a certain stock seems to be falling in value. There is no material news, and the overall markets have been climbing.

If you look at the RSI, and it was very high and has been coming down over the last few days, or week, you may be able to assume that the overbought condition is starting to normalize.

While the RSI is pretty reliable, especially compared to most other technical indicators, there is a flaw (There always seems to be a catch with everything, and the Relative Strength Index is no different).

Specifically, while any stock with an RSI of 25 is heavily oversold, that selling can still increase from here, and may even take the level down towards 20, or even 15. During that decrease, the price may slide, and investors leaning too heavily on RSI can be looking at an investment loss (on paper at least).

This is why I suggest patience (because the stock almost always will come back from an oversold situation), and to look at the bigger picture, rather than relying on one single technical analysis indicator on its own.