TD Ameritrade
This video explains the Relative Strength Index, its calculation and how it can be used to identify potential trading signals, oversold and overbought conditions, and trend reversals. However, its signals may not always be accurate and require confirmation from other indicators.
Introduction
The Relative Strength Index, or RSI, is an important indicator used by investors to measure momentum and identify oversold or overbought conditions. It can help investors make informed decisions about trading signals and trend reversals. In this article, we will discuss how to calculate RSI, how it measures momentum, and how investors can use it to identify potential trading signals and trend reversals.
How to Calculate RSI
The RSI is calculated by first selecting a previous time period, which is usually 14 days but can be shorter or longer. Then, the average gains and losses during this time period are added up and divided to obtain the relative strength value. The relative strength value is then plotted on a graph between zero and 100, allowing investors to measure momentum in relative terms.
Measuring Momentum with RSI
By comparing the indicator’s current value to past values, investors can identify potential trend reversals. There are two important ranges of the indicator to keep in mind: overbought and oversold. Overbought stocks have increased rapidly in a short period of time and may reverse lower, while oversold stocks have decreased sharply in a short period of time and may reverse higher.
Using RSI for Trading Signals
Investors can use RSI to identify potential trading signals by defining oversold as an RSI value below 30 and overbought as an RSI value above 70. When RSI crosses back above 30, it generates a potential bullish entry signal, while when RSI crosses back below 70, it generates a potential exit signal.
Using RSI for Trend Reversals
RSI can also be used to spot potential trend reversals, confirmed by divergences between price and RSI. A bullish divergence occurs when a stock makes lower lows but RSI makes higher lows, signaling downward momentum is waning and a bullish reversal may follow. Meanwhile, a bearish divergence occurs when a stock shows higher highs but RSI shows lower highs, indicating upward momentum is slowing and a bearish reversal may occur.
The Risks of Using RSI
While RSI is a valuable indicator, its signals are not always accurate. It cannot factor in fundamental aspects such as economic news, earnings, and other influences that may affect a stock’s price. Additionally, RSI can remain overbought or oversold for an extended period. Using RSI also requires subjectivity that benefits from hindsight, so it is usually used in conjunction with other forms of confirmation such as volume and the overall trend in the broader stock market.
Conclusion
In conclusion, RSI is an important indicator used by investors to measure momentum, identify oversold or overbought conditions, and find potential trading signals and trend reversals. Although it has its limitations, investors who incorporate the indicator into their trading may find the insights and context it provides to be beneficial.
