One relatively simple way of making money in the stock market is by profiting from stocks with Relative Strength Index (RSI) readings that indicate when to buy and sell stocks. Some traders primarily use the Relative Strength Index to find stocks that they believe will continue to go up and represent good short to medium term buying opportunities. They also use the Relative Strength Index to determine when stocks have become overbought and should be sold.
It may seem counterintuitive to any stock trader that likes to delve into every indictor and metric concerning a stock that they want to buy; however, just buying and selling stocks based on their Relative Strength Index readings has proven to be simple, yet profitable, stock trading strategy for many astute traders. This is why learning how the Relative Strength Index provides buy and sell signals for stocks is worthwhile for any stock trader that wants to be successful and make money.
What Is The Relative Strength Index (RSI)?
The Relative Strength Index a technical momentum indicator that provides an indication regarding whether a stock is at a point where it is at a good level to buy or sell, based on a stock’s trading pattern and momentum. It also indicates whether momentum should continue to carry a stock to a higher level when a stock is making a move higher. In other words, it can be used to gauge when and how long to hold onto a stock that is an uptrend, since it provides guidance regarding the strength of the uptrend and a warning when the uptrend may be reaching a peak.
If you would like to understand the how the Relative Strength Index of a stock is calculated, here is a technical explanation. Relative Strength Index is a technical momentum indicator that takes into consideration the magnitude of recent gains versus recent losses in a stock’s daily trading activity to provide the Relative Strength Index number. This number can be used to assess whether a stock is oversold and is at a price level that presents a good buying opportunity or is overbought and is at a price level at which taking profits may be the best course of action.
The Relative Strength Index for a stock is calculated using the following formula: RSI = 100 – 100/(1 + RS). RS stands for Relative Strength and is the average of the number of days a stock closes up, divided by the average number of days a stock closes down. The Relative Strength Index is essentially a momentum indicator that tells a trader if a stock has reached a level where momentum indicates an up or down move is imminent. Some traders use volume to confirm the findings of the Relative Strength Index, since bottoms and tops in stocks are often accompanied by increased trading volume, as traders get into or out of stocks at perceived bottoms and tops.
Traders also use other indicators in conjunction with the Relative Strength Index, such as 50 and 200 day moving averages to help them confirm buy and sell levels for stocks. However, it is possible to just use Relative Strength Index on its own, since it is such a solid, albeit not foolproof, indicator of bottoms and tops for stocks. Studies have shown that approximately 80% of stocks that have upward momentum one year will continue with the upward momentum into the next year. The Relative Strength Index is an excellent tool to trade into and out of these stocks that are in a long-term uptrend.
How Does The Relative Strength Index (RSI) Work?
The beauty of the Relative Strength Index is that it is not complicated at all. There are four components to the Relative Strength Index.
- If a stock is below the 30 Relative Strength Index level and has leveled off, it is sending a buy signal.
- When a stock trends higher to the 50 Relative Strength Index level, a strong buy signal is triggered.
- When a stock has a Relative Strength Index reading between 50 and 70, the stock is in a strong upside rally.
- When a stock crosses the Relative Strength Index level of 70 and trades above 70, the stock is more often than not reach an overbought condition and should be sold ahead of a pending pullback.
That is it! Simple right? You buy a stock when the Relative Strength Index is below 30, hold it when it is between 30 and 70 and sell it when it gets above 70. Some traders use wider buy and sell bands to provide a buffer to confirm that a bottom or top is actually in, based on the Relative Strength Index reading. For example, more conservative traders may buy when the Relative Strength Index hits 25 for a stock and sell when it hits 75.
The Relative Strength Index seems to work best when a stock has gone through a relatively mundane trading period with normal to below normal volume. When it indicates a buy below a 30 Relative Strength Index reading, or a sell above 70 Relative Strength Index reading that coincide with a pick-up in volume, it is a strong indication that an actual bottom or top is in. At this point, the Relative Strength Index can be used to execute a trade. Use the Relative Strength Index with caution when a stock has a steep sell-off or a big spike in price, as the indications provided by the Relative Strength Index may be skewed under conditions in which a stock is experience dramatic price swings.