Trading is all about the timing. Having an understanding of when to buy or sell a stock can make all the difference between becoming profitable or bearing a loss. That’s where tools like the Relative Strength Index (RSI) prove to be useful.
Think of RSI as your guide to help you identify when a stock might have too many buyers or sellers.
Understanding this technical analysis tool can impact your ability to spot opportunities or avoid risks. Let’s explore how this indicator works and how you can use it to make better decisions. Let’s get started!
What Is the Relative Strength Index?
Relative Strength Index or RSI is an analysis tool that helps traders understand stock trends. This tool is used in technical analysis and it checks how fast and how much stock prices change. The scale it uses is from 0 to 100.
When this tool surpasses 70, it gives us an idea that a stock might be bought in excess. If it declines below 30, the stock could be sold excessively. These points hint that the stock price might soon change direction.
J. Welles Wilder Jr. came up with RSI in 1978. He wanted to give traders a way to quantify how strong a stock’s price trend is. This is one of the best trading indicators used by traders across the world.
Why Do Overbought and Oversold Conditions Matter?
When a stock is overbought, it means the price has shot up fast, often because of excessive demand. This might mean that the stock is overpriced and could be corrected. On the other hand, an oversold stock means that the price has dropped, which could make it a good deal to buy.
Let’s look at what happened during COVID-19. Indian drug company stocks became overbought as everyone wanted them. Smart investors who used RSI didn’t buy when prices were at their highest.
At the same time, many bank stocks were oversold when lockdowns started, giving investors a chance to buy at a low price. Such things can be identified by using tools like RSI.
How Does RSI Spot Overbought & Oversold Conditions?
In this section, let’s understand how RSI works:
1. Spotting Overbought Conditions
When the RSI crosses 70, it could mean that a company’s stock is bought more than it should. This means the price is too high because of a lot of people buying it.
Let’s say a well-known IT stock like Infosys sees its RSI jump to 75 after reporting good quarterly earnings. Traders might take this as a hint to sell, thinking the price will drop soon after correction.
2. Spotting Oversold Conditions
If RSI drops below 30, the stock could be oversold and worth less than it should be. This means that it is a good time for you to invest in the stock.
For example, in 2022 many small-cap stocks in India had their RSI fall below 30 because people were worried about a global recession. Investors who bought during this time made money when the market got better.
3. Identifying Divergences
Divergences take place when stock prices and RSI go in other directions. A positive divergence (when the price hits a new low, but RSI hits a higher low) hints that the stock might rise soon.
Whereas, a negative divergence (when the price of a stock touches a new high, but RSI hits a lower high) gives us a hint of a potential drop.
Tips for Using RSI Effectively
Here are a few tips for how you can use RSI effectively:
Adjust the Time Frame
The standard RSI setting covers 14 days, but you can modify it to match your strategy. Traders focused on short periods might pick a 7-day RSI to get faster signals, while investors looking at longer terms may choose a 21-day RSI to see smoother trends.
Combine RSI with Other Indicators
RSI works best when you use it along with other methods like moving averages, Bollinger Bands, or MACD. For example, if RSI shows that a stock is oversold and its price is close to a strong support level, this double check strengthens your decision to buy.
Be Cautious in Trending Markets
When there are strong upward movements, RSI often stays beyond 70 for long periods. In downward trends, it remains below 30. At these times, you should rely on additional indicators to steer clear of false signals.
Watch for Breakouts
RSI can also point to possible breakouts. For example, when a stock’s RSI goes over 50 after being below 30, it often means a new upward trend is starting.
Avoid Mistakes
- Ignoring the Trend: RSI signals are less reliable during strong trends. Always consider the broader market context.
- Over-Reliance on RSI: Use RSI as a guide, not a rulebook. Using it alongside fundamental analysis will lead to more balanced decisions.
- Reacting to Every Signal: Not every RSI crossing 70 or 30 requires action. Use additional indicators to confirm your moves.
Wrapping Up
The RSI, often considered in the top 20 trading indicators, is a solid yet easy tool to understand overbought and oversold conditions. Whether you’re new to investing or have years of experience, RSI can help you time your trades better.
But no tool is perfect. Always use RSI with other indicators and fundamental analysis to make smart decisions. In India’s ever-changing stock market, knowing how to use tools like RSI can give you a big advantage.
