One of the most widely used technical indicators in stock trading is the Relative Strength Index or RSI. The RSI is used to gauge price action momentum through a line graph that moves in between overbought and oversold conditions. This was developed by J. Welles Wilder Jr. and was since adopted by many technical analysts as a primary means of evaluating strength in buying and selling momentum.
How to Read the RSI
Interpreting RSI information is straightforward and must always be analyzed in conjunction with the price. This allow traders to smoothen the area of value in the chart and validate any potential reversals.
The classic interpretation of RSI is that price is due for a trend reversal from an uptrend when it reaches 70 and is bound to reverse from a downtrend when it reaches 30. This however varies from different chart setups and must be validated by volume and other technical indicators as necessary.
For the most part, the RSI is used to generate buy or sell signals when it lines up alongside price action patterns on key levels. We'll outline some of these signals later to illustrate it better.
It is important to note that the RSI can stay for extended periods of time in the Overbought level during a strong uptrend and can stay for prolonged periods in the Oversold level during a downtrend.
Key RSI Levels:
RSI below 30
RSI moving below 30 is a bearish signal. This is indicative of heavy selling pressure which is translated as a breakdown in price. However, it can also be used as a bounce signal as price usually makes a brief bounce when RSI moves between 20-30 (given that the stock is not plagued with any fundamental risk).
RSI above 50
RSI above 50 is a bullish signal. Cases wherein RSI is moving past 50 is indicative of increasing buying pressure. Price usually pivots from a consolidation and is setting up for a momentum move. Usually, RSI will encounter selling pressure as it nears RSI 70 and a pullback or consolidation takes place.
RSI above 70
RSI moving above 70 is indicative of strong buying pressure. In most cases, when RSI breaks out above 70, a parabolic spike in price happens. This is a case to case basis per stock but strong parabolic rallies will reach RSI 80-90 before profit taking ensues.
Examples of How to Use RSI in Trading
1. Plotting divergences
Bullish and bearish divergences are formed when there is a divergence between the price and the RSI. This is a classic reversal formation that have been consistently used to determine potential market reversals.
A Divergence can be simply illustrated when the stock price is moving in the opposite direction of an oscillator (usually the RSI). This means that the strength in buying or selling is weakening and the price will likely shift in trend.
a. Bullish Divergence
A Bullish Divergence is illustrated in the chart when the RSI starts to make a new higher low while the price of the stock is establishing a new lower low. This signifies weakening selling pressure that might result to an uptrend shift.
b. Bearish Divergence
A Bearish Divergence is illustrated in the chart when the RSI starts to make a new lower high while the price of the stock is establishing a new higher high. This signifies weakening buying pressure that might result to a downtrend shift.
2. Gauging price REVERSAL POINTS
When plotting possible reversal points, gauging the right support and resistance levels maybe tricky. When buying or selling pressure are strong, most support and resistance levels will not hold. This is when the RSI can be an effective tool in augmenting chart analysis. As RSI hits 30 and below the oversold area, chances of a price bounce increases. Inversely, when RSI hits 70 and above the overbought area, a chance for a price rejection increases.
The price chart above is a perfect example of how price swings respond to key RSI levels. Notice that price peaks and pulls back when RSI hits 70 and bounces when it hits 30. This is especially useful to generate swing plays wherein a specific entry and exit point is needed.
3. Assessing strength of buying and selling
Volume validates price action. RSI confirms this when a spike up in buying volume occurs when RSI is above 50 - 70 or when a spike in selling volume happens when RSI is at 30.
When volume, RSI and price action signals all agree, this means that the move is strong and that the trader needs to put more weight on the signal.
a. RSI movement during price breakdown
To validate breakdown and capitulation patterns RSI should be moving below 20 - 30 paired with increasing volume.
As seen in the chart below, price breaks down below support paired with RSI diving below 30 with a spike up in volume. This is indicative of a capitulation or a downtrend move.
b. RSI movement during price breakout
To validate momentum and breakout patterns RSI should be moving above 60 - 70 paired with increasing volume.
As seen in the chart below, price breaks out above resistance paired with the RSI moving above 50 and reaching 70 with a spike up in volume. This is indicative of a momentum or uptrend move.
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