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Financial Literacy

RSI: The Ultimate Overbought/Oversold Indicator

Timing the market is largely a fool’s errand.

Countless investors have searched in vain for a foolproof indicator that will give them the precise time to enter or exit the market…

So far, to no avail.

But while perfect market timing may not be attainable, technical analysis offers investors a variety of tools that assist in making smarter trading decisions.

In another article, I showed you how moving averages (MAs) can act as bullish or bearish signals. Today, we’re going to focus on another indicator, one that gives us entry and exit signals based on the speed and magnitude of a stock’s price action.

It’s called the relative strength index – or RSI, for short. You’ve probably heard it mentioned in Investment U before.

The best way to think of the RSI is as a thermometer for stocks. It allows you to gauge if a stock is “hot” or “cold” – specifically, if it’s too hot or cold.

Using Buy/Sell Signals – Is the Stock Hot… or Not?

Before we jump into how to determine the “temperature” of a stock, we need to cover how you gauge the RSI.

Simply put, the RSI’s value oscillates between 0 and 100. It’s calculated using the average gains and losses over a fixed period time – typically the last 14 days.

A stock’s price movements tend to stay within this temperature range when it’s trading normally. I call this the “Goldilocks Zone.”

You can see it in the chart above. The Goldilocks Zone is right between 30 and 70: not too hot and not too cold. It’s just right.

But we don’t want to stop there. There are bullish and bearish trends you can identify when the RSI moves in and out of the Goldilocks Zone.

For example, when it rises above 70, the stock price is typically considered too hot, or overbought. Crossing back below 70 is therefore a bearish signal that the stock is cooling down.

But when the RSI drops below 30, it’s considered too cold, or oversold. And a crossover back above that figure is a bullish signal that the stock is warming up.

Make sense?

Some chartists prefer using a stricter criteria, with 80 and 20 marking the overbought and oversold levels. But for now, let’s stick with the standard 70 and 30 in analyzing a past Chipotle (NYSE: CMG) chart.

Here, we have four signals suggesting two potential trades.

Our indicator revealed a buy opportunity on January 30, 2014, with the stock closing at $493.96.

See that first sell signal? On March 15, 2014, the stock closed at $581.25 and the RSI fell below 70. If we acted then, we would’ve booked a double-digit gain (17.7%) in just over a month.

Another buying opportunity presented itself on April 29, 2014, when the stock ended the day at $491.57. The next sell signal then came on June 10, 2014, with a closing price of $564.76.

This time, we would have earned 14.9%.

With results like these, it’s no wonder many traders use these indicators to gauge the right time to enter and exit their trades.

Of course, it’s important to understand the RSI’s limitations as well.

Sometimes a stock will repeatedly hit either its overbought or oversold level – meaning it’s experiencing significant growth or decline. When this happens, there’s no guarantee prices will continue trending upward or downward. The indicator simply puts the odds in our favor.

To illustrate this, here is a price chart for Microsoft Corp. (Nasdaq: MSFT)…

As you can see, on August 26, the RSI crossed above 30, suggesting that the stock was heating up. We have our buy signal. On that day, the stock price closed at $42.71. So let’s assume we bought and held until we found our sell signal.

That sell signal came on November 10, when Microsoft crossed below 70, indicating the stock was cooling. Shares closed at $53.51 that day, which would have prompted us to close the position for a 25.3% gain in under three months.

With that said, it should be noted that the uptrend continued after we exited the trade. So a drop below 70 obviously isn’t a guarantee that a downtrend has started. It simply indicates one is highly probable.

Customize Your Parameters

With the two previous examples, we’ve used the RSI’s default setting of 14 days for our temperature gauge, as suggested by its creator, J. Welles Wilder. However, to really take advantage of the indicator’s potential, it’s best to customize your parameters to the stock you’re analyzing.

So let’s switch things up a bit for our next illustration…

It’s obvious that Shake Shack (NYSE: SHAK) is in a downtrend. But is it possible to profit from the price swings within the larger trend? Let’s see if the RSI can help us…

Below is a chart comparing different RSI settings for the same stock. First up, we have the standard 14-day setup. The second is for half that timeframe (seven days), and the third is twice as long (28 days).

In the five-month period outlined above, our default 14-day RSI gave us a buy signal but no timely sell signal. Cutting it to seven days provided plenty of buy and sell signals, all of which would have led to profitable trades. But our 28-day RSI gave us nothing in this situation.

Why did the settings give us such different results? It’s simple. A shorter timeline makes the indicator more sensitive to shorter-term price movements. A longer timeline makes it less so.

That sensitivity determines how frequently buy and sell signals are issued.

For more volatile stocks like Netflix (Nasdaq: NFLX), you’ll want the sensitivity to be low so that you only capture the significant price swings. And for more stable stocks like Johnson & Johnson (NYSE: JNJ), you’ll want the RSI to be more sensitive with a shorter timeframe.

In the end, the key to the RSI’s effectiveness is adjusting the parameters so that they give you the results you’re looking for. In fact, the same is true for most technical indicators.

But as we’ve mentioned before, technical analysis is not perfect. Indicators should always be used in conjunction with others and next to a thorough look at the company’s fundamentals.

Using them successfully takes times and practice. But they play an important role in an investor’s research toolbox.

With RSI at your disposal, executing profitable trades does become much easier.

Good investing,

Anthony


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