Relative Strength Index Overview
First if is important to not confuse the RSI (Relative Strength Index) technical indicator with the Relative Strength fundamental criteria. Relative Strength compares the price of a stock to an index (or another stock) over a period of time and performs a comparison; while the RSI momentum oscillator compares the magnitude of a stock's recent gains to the magnitude of its own recent losses and transforms that information into a number that ranges from 0 to 100.
Relative Strength Index was developed by J. Welles Wilder and introduced in his 1978 book, New Concepts in Technical Trading Systems. The basic components include the Average Gain, the Average Loss, and the calculated RS values over a period of 14 days. RSI converts the underlying information as an index that runs from 0 to 100. High values of RSI are generally considered an indication that the stock is overbought while low values are regarded as oversold.
The HingeFire tool provides support to incorporate RSI in your creation of screens for stocks. Support for multiple common levels is included. Users can scan to determine if a Relative Strength Index is greater than or less than a particular level, and also establish if the RSI just crossed above (JCA) or below (JCB) a threshold.
In his book, Wilder recommended using 70 and 30 and overbought and oversold levels respectively. His work postulated that if the RSI rose above 30 then it is considered bullish for the underlying stock. Conversely, an RSI dropping below70 is a bearish signal. Some traders identify the long-term trend and then use extreme RSI readings as entry points. For example if the long-term trend is bullish, then oversold RSI readings could denote possible entry points.
Since the time of the original RSI work from Wilder, many traders have adopted the 20 and 80 levels of RSI as the levels of most interest instead of 30 and 70. Which levels are of most value is regular subject of theoretical debate. The 20 and 80 RSI levels represent greater extremes that operate better in more volatile markets. Investors should try both and determine which are most useful for their stock selection process. The HingeFire tool provides support for all of these levels.
RSI is a momentum oscillator and a solid indicator of medium term trends. Investors normally use RSI to time transactions or to filter stocks to exclude.
Stocks with an RSI below 30 or 20 are considered to be oversold. Some oversold stocks are due for a bounce back. Others have negative fundamental and trend information associated with them and may continue to dive in price. A number of investors screen for stocks with low RSIs and then sort through the results to see if any gems are available at attractive prices.
Avnet Inc (AVT) recently endured a downtrend and has arrived at an RSI level below 30 which indicates that the stock has entered oversold territory. If an investor believes that the long term fundamentals associated with the stock are sound then they may select this as an entry purchase point and expect the stock to reverse the trend as the selling fizzles out.
Stocks with RSI levels above 70 or 80 are considered over bought. A number of these stocks may continue to rise and exhibit high RSI readings for a period of time. A good quantity of these stocks are due for a tumble however as they approach an exhaustion level of available purchasers in the market. A number of traders screen for high RSI levels and then review the charts for possible short candidates.
The RSI for Suntech Power Holdings (STP) recently crossed above 70 again. Note the previous price retrenchments of more then $8.00 when the RSI indicator rose above 70 in late October and early November as buying was exhausted.
A number of investors filter their potential purchase decisions with an RSI level of above 20. This will exclude stocks that are demonstrating continually lower days which have the possibility of dropping further over the upcoming weeks.
Investors focused on shorting stocks will filter the market for candidates with an RSI below 80. This avoids stocks exhibiting continually higher days that may continue to increase in price for a period of time (until exhaustion occurs).
Break above Oversold
One of the most common uses for RSI is to scan for stocks that just broke above the oversold condition and now should continue to rise. The HingeFire tool supports searching for stocks that just crossed above (JCA) various thresholds. A breakout above 20 or 30 indicates a solid change in momentum for a stock as it exits an oversold condition while increasing purchases occur.
Wyndham Worldwide (WYN) recently experienced a spree of selling with an associated drop in price over the past several weeks. The RSI just crossed above the 30 level which may be a signal that the downward momentum is broken and the stock price has potential to rise.
Inversely, another common use for RSI is to look for stocks that have just crossed below (JCB) the overbought condition at the 70 or 80 level. This normally serves as notice that the stock may continue to fall over the upcoming few weeks. Sometimes the stock will revert on increasing volume into the overbought condition again if new buyers flood the market; more normally this indicates the start of a medium term reduction in purchasers for the equity.
The RSI for Saul Centers (BFS) recently just crossed below (JCB) the 70 level. Note the several week downtrend that occurred with the stock after the RSI dropped below70 in mid- October. At this point the buying was confirmed to be exhausted and BFS continued to drop in price.
Some investors simply want to avoid extremes when timing their stock transactions. These investors will filter their decisions with an RSI >= 20 and < 80 (or use 30 and 70). This type of filter enables investors to avoid stocks that are currently in greatly oversold or overbought conditions. In many ways, this is a method of reducing volatility risk for long term investors.
A number of investors look at RSI on charts to scrutinize for divergences between RSI and the price trend of the stock. There are also investors who utilize the mid-point of 50 as a single break level between rising and falling prices; however most screens based on midpoint show no real potential unless the investor evaluates the associated chart information. The most common utilization of RSI however is screening for oversold and overbought levels as outlined above.
Summing up, many astute investors use the HingeFire tool to screen for the following situations with Relative Strength Index.
Oversold Territory – Screening for stocks with RSI levels below 20 or 30.
Overbought Territory – Screening for stocks with RSI levels above 70 or 80.
Filtering Buys – Looking to purchase stocks only with RSI levels above 20.
Filtering Sells – Looking to only short stocks with RSI levels below 80.
Break Above Oversold – Screening for stocks that JCA the 20 or 30 level.
Break Below Overbought – Screening for stocks that JCB the 70 or 80 level.
Avoiding Extremes – Screening for stocks only between 20 and 80 (or 30 and 70).
Combining technical indicators such as Relative Strength Indicator with commonly used fundamental criteria when selecting your investments helps put the market edge in your corner. The RSI support in the HingeFire Stock Screener adds a powerful tool for timing your buy and sell transactions to pull excess alpha out of the market.