Have you ever heard someone talking about a stock and mention that it looks like it is either overbought or oversold? The chances are good that they were using a certain indicator to make that determination.
As traders, it’s always a good idea to seek out new knowledge and indicators and learn about how they can help us make better trading decisions. The problem is that there are so many indicators to choose from, it can be difficult to sort through which ones are valuable and which ones don’t have a lot to offer our trading styles. RSI is one of the most popular indicators in the trading world for good reason. It helps us determine the speed and change of price movements of a security. Tons of traders use this indicator when performing technical analysis, so it’s a good idea to at least gain a basic understanding of why it can add value. In this article, we are going to take a deeper look at RSI and why it is useful.
Relative Strength Index Defined
RSI, or Relative Strength Index, is a momentum oscillator that was first created by a man named J. Welles Wilder Jr. in 1978. It’s still around after all of these years, which tells us just how valuable it is considered inside the trading community. In basic terms, a momentum oscillator means that it’s an indicator that operates within a band or a defined range of numbers, usually between a scale of 0 and 100. Oscillators are helpful in trading because they provide a line graph that visually moves back and forth between two extremes. One quick glance at a graph of RSI can provide you with instant information. The formula used to calculate RSI might seem complicated upon first look, but it is a lot easier to digest when you see it graphed on a chart.
Many traders use RSI to take a look at the velocity and magnitude of price movements. They use RSI to look for overbought or oversold conditions for a security they are interested in trading. You can use RSI to take a look at current market conditions as well since it can let you know whether a lot of selling or buying is occurring in the market.
There are several benefits to incorporating RSI into your technical analysis and trading. One of the biggest advantages to using it is that it can help us with identifying Overbought & Oversold Conditions
If you are a trader looking at a stock chart, one of your main goals is to try to locate a trend in the price movements. RSI is a great indicator of that since it visually displays price momentum. You can look at the RSI oscillator mapped below the price graph of a security and pretty much instantly recognize whether or not it is oversold or overbought. RSI values that are 70 or above usually mean that the security is becoming overbought or overvalued. This is important to note because when securities are overbought or overvalued, they are likely to experience a trend reversal. The opposite is true if the RSI reading of a security is 30 or below, which signifies that a security is oversold or undervalued.
RSI can be very helpful for traders, especially if they are able to comprehend its limitations. There is no such thing as the perfect indicator, RSI included. Actual market conditions can sometimes differentiate between technical indicators like RSI. That means it’s important to take indicators like RSI with a grain of salt. Even if a stock is overbought based on the RSI indicator, it can still go higher. The same is true when RSI is telling us that a stock is oversold with an RSI of 20. You can’t simply assume that a security has bottomed out just because the RSI is telling is it is oversold.
The best way to use RSI is in combination with other indicators and technical parameters to obtain the most compelling trading signals. You also need to ask yourself about the unique characteristics of the underlying security you are looking at when determining the best indicators to use. The next time you are trying to identify a trend, try to take a look at the security’s RSI and see if you can pick up on something new.