RSI and How You Can Leverage It

Last Updated on January 15, 2019 by Sultan Beardsley

Key Points

• RSI can help you decide whether you should buy or sell
• RSI can help identify how undervalued/overvalued the stock is

Background

RSI; Relative Strength Index is a measure of recent price changes and an indicator of  directional change introduced by J. Welles WIlder. Many investors use this tool to help them determine if a stock has entered overbought or oversold territory. RSI can serve as one aspect of your technical analysis arsenal and supplement other indicators to help formulate an investment thesis. At MS we have found it useful in our decision making process for identifying swing trades. It is worth noting that; while RSI proves insightful in many cases, just like other technical tools, it is imperfect and should be used to compliment your investment thesis, not make it.

Calculation

For those of our readers who are more technically intrigued and wish to apply the strategy to current plays, the formula is as follows:

• RSI=100-100/(1+RS)

RS=Average Gain/Average Loss

Average Gain = Gains/n

Average Loss = Losses/n

(take totals for gain and losses values)

n= number of RSI periods for calculation

RSI is typically calculated over 14 periods as suggested by J. Welles Wilder. This means our n will equal 14.

For those of you who are less excited by equations and want a quick update on the numbers you seek, bigcharts from marketwatch has a tool depicted below you can use to track RSI in relation to current price action for free. We will be using TD Ameritrade  in explaining examples in this article because it allows more interaction with trend lines, and is the platform we trade on. The picture taken on bigcharts provides a quick glimpse of the functions (left side bar) and output you can expect to see.

RSI in Action

We will now take a look back at one of our first articles on GALT where we argued it was oversold, undervalued and poised for a positive shift in price action. MS hit the mark as the share price flirted with the the $7 range before attracting short interest, among other things, and being bashed down to baseline levels. A close look at the technicicals from late August through October reveals the RSI relationship with directional shifts in price action for GALT. 

In this image we see the RSI dipping well below 20, an indication of being oversold. As you can see this RSI below 20 did in fact serve as a valid bullish indicator and was followed by a sizable upside. In contrast, RSI can help us decide when to let go of a stock. As seen in the image below, GALT bounced from ~$3.85 as the RSI data suggested, but soon reached “overbought” levels (RSI of 70-80), suggesting downside in its near future. The RSI plays around the 70 mark indicating reversal in accordance with the equation and finds itself retracing toward baseline levels. 

As you can see, RSI can be extremely valuable in swing trading and beyond. It helps us as investors identify good entry and exit points. Furthermore, RSI can add confidence to our moves, yet warn us once we approach levels appropriate for profit taking.

Remember, “you can’t marry a stock, you can only date them!”

Key Takeaways

• RSI ranges from 1-100
  • 30 is deemed oversold and suggests there is potential upside
  • 70 suggests the stock is overbought and due for correction
• RSI can help you identify a good range and advise you when you to enter and exit
• Although valuable to investors, RSI is best used in combination with due diligence (DD) and other tools to create the strongest investment strategy possible.
• The recommended RSI ranges indicating a stock being overbought or oversold is more of a general rule. In our experience we’ve found that each stock has an RSI range unique to it. It’s up to you to become intune with it.

Lets get it!