Stocks have trading rhythms, and technical analysis is how you can interpret those price movements to identify attractive buy and sell points. Increasing profits while reducing risk is the name of the game here. This is especially valuable in a volatile market, when price swings can be hard to stomach for a lot of investors.
When you hear the term technical analysis, you may have visions of fancy tools and confusing charts with lots of arrows and scribbles. While it can get complex and a bit overwhelming, I really use technical analysis to look at the direction – or trend – of a stock and analyze whether there is enough supply and demand in the market to keep that trend going in the future.
There are several tools in my arsenal that I use during analysis, and today, I thought it would be interesting to discuss the one that I use most often to not just identify a trend but also profitable entry and exit points within that trend: the relative strength index (RSI).
This is a go-to tool for me. It measures speed and direction of price movement over a period of time, and it’s useful in determining when a stock is oversold and ready for a bounce or overbought and ready for a pullback.
Stocks rarely trade against the market forever or even for very long. Odds are good that a stock that has defied underlying trends for a long time will have to reverse direction and deliver an outsized move in order to catch up. A stock that has gone down too far behind the broad market has had a lot of selling pressure pushing it down – this is called oversold. A stock that has rallied too farahead of the market will eventually run out of steam and/or hit a wall – this danger is when a stock is overbought.
The RSI is plotted in a range between zero and 100. Readings at different points along this range tell us a little more clearly which direction a stock is headed.
Below 30: An RSI below 30 indicates that a stock has been pushed into technical oversold position. It can still fall further, but at this point the divergence between its performance and the broad market is getting wide. On the other hand, a reading above 30 gives us confirmation that the divergence is narrowing again and the stock is bouncing. Depending on how deep the dip has been, even a bounce can make good money – especially in a volatile market. The underlying mood on the stock hasn’t changed, it’s simply how the math works out in a market where every position is connected to everything else.
30-50: A reading between 30 and 50 is still lukewarm at best. The stock is weaker than the market and will tend to float around at this level.
50-70: When the RSI edges above 50, it is technically rallying ahead of the market. This is a great point to be at. Momentum often feeds on itself, so good news is a self-perpetuating cycle.
Above 70: RSI at or near 70 can start to look overheated or overbought. The stock can cross this line, but at this level it is critical that sentiment remains euphoric for it to keep moving higher, which isn’t always easy for a company. But if it does, a stock can exist above 70 for weeks or even months and keep climbing. When the RSI dips below 70 and doesn’t regain that level quickly, this indicates that the rally has probably peaked. At that point, it’s best to either cash in or hang on for the next cycle.
One thing you may like about the RSI is that it’s pretty straightforward. Ideally, I like to open trades when the RSI is above 50 but below 70 – good momentum but not overbought. I also sometimes scoop up stocks that are oversold with an RSI down around 30, especially when there are other factors that make a bounce from those oversold conditions probable.
I hope today’s blog has given you a little insight into technical analysis and a tool you can use to help break charts down!