- The relative strength index (RSI) provides short-term buy and sell signals.
- Low RSI levels (below 30) generate buy signals. High RSI levels (above 70) generate sell signals.
- The S&P 500’s RSI is rising, with a sell signal possibly on the horizon.
RSI in context
US midterm election voting concluded earlier this month, and investors are back to focusing on the fundamentals and technicals of the market. Third quarter earnings season is winding down, and most companies have delivered strong results. Based on 90% of the S&P 500 having reported earnings, 78% topped their earnings estimate.
From a chart perspective, there are reasons to be both positive and negative on the stock market. While US stocks are essentially flat on the year, markets have stabilized from the October swoon. However, according to one indicator, RSI, short-term active investors may want to stay vigilant to see what could be next.
RSI in context
It's important to begin your investment process with a long-term plan that is built upon your individual goals, risk tolerance, time horizon, liquidity requirements, and tax constraints. Picking your investments should start with careful fundamental analysis. As an adjunct to fundamental analysis, technical analysis can play a role in identifying entry or exit points for a stock, in spotting emerging changes that may not yet be reflected in fundamental estimates for a company or industry, and as a reality check on fundamental expectations about a stock, an industry, and, at times, even the broad market as a whole.
Among the many technical tools that you can use to compliment your analysis of stocks and other investment opportunities is RSI, which measures the speed and change of price movements. It is intended to evaluate the relative value of a stock—based on its recent price history. Among technical indicators, RSI is one of the more commonly used due to the relatively simple, straightforward signals that it generates.
RSI is a so-called momentum oscillator, a type of technical indicator that fluctuates in a range, usually from 0 to 100. RSI is used primarily to determine whether a stock, index, or other investment is overbought or oversold. It is calculated using the average gain and average loss over a defined period of time (see the full formula).
Like other oscillators, RSI is most helpful in non-trending markets—like the one we appear to be in now. A non-trending market exists when a stock, index, or other investment’s price is fluctuating in a range between 2 prices. Non-trending markets might be identified by a broad market index, such as the S&P 500, failing to reach new highs or lows over a period of time—such as several weeks or months. The chart below shows how the S&P 500 has traded between 2,581 and 2,935 thus far this year. More recently, it has traded between 2,600 and 2,815 over the past month.
Investors using RSI generally stick to a couple of simple rules. First, low RSI levels, typically below 30, indicate oversold conditions—generating a potential buy signal. Conversely, high RSI levels, typically above 70, indicate overbought conditions—generating a potential sell signal.
Some users of RSI and other indicators adjust the rules based on their own preferences and analysis. Instead of using 30 and 70 as oversold and overbought levels, one common modification that you might employ is to widen the parameters to 20 and 80. Here, if RSI were to drop to 20, that would generate a buy signal. Alternatively, if RSI were to rise to 80, this would generate a sell signal.
Trading signals generated by RSI are generally thought to be most valid when values reach an extreme reading near the upper or lower end of the boundaries. Thus, an RSI reading near 100 (the top of the RSI scale) would be strong evidence of overbought conditions (a sell signal), while an RSI reading near 0 (the bottom of the RSI scale) would suggest oversold conditions (a buy signal).
Looking at the chart above of the S&P 500® Index ( .SPX ), you can see that large-cap stocks are little changed on the year. Currently, RSI is near 45, which is neither a buy nor a sell signal. If RSI were to rise above 70 (or 80, depending on your preference), that would generate a short-term sell signal. Alternatively, if RSI were to fall to 30 (or 20, depending on your preference), that would generate a short-term buy signal.
For example, the last signal was registered in October when RSI dropped below 30 on the 24th, generating a buy signal.
It is important to recognize that, in addition to trading signals being considered more significant when RSI reaches extreme readings near 100 and 0, trading signals are also given more credence when the reading rises above 70 and stays above that level for an extended period of time, or drops below 30 and stays below that level for an extended period of time. Consequently, the buy signal generated in October is not considered a strong one, given that RSI dropped below 30 for only a day.
It is worth noting as well that RSI can remain in overbought or oversold territory for an extended period of time (weeks or even months). That is, if RSI were to eventually move above 70 or below 30, it would not be uncommon for it to remain above or below those levels for some period of time without retreating back to neutral territory.
In addition to the overbought and oversold signals that RSI can generate, it is possible to dig a little deeper into the relationship between RSI and the price action of the stock or index.
A positive reversal, for example, might occur when RSI makes a lower low (a relative low point on the chart that is below the most recent previous low) but the price is starting to make a higher low (a relative low on the chart that is higher than the most recent previous low). This would be a bullish move, generating a buy signal. A negative reversal could occur when RSI forms a higher high, but the price forms a lower high. This would be a bearish move, generating a sell signal. The S&P 500 has not recently exhibited a positive or negative reversal.
RSI in action
Basing trading decisions solely on any one indicator could result in poor analysis. Most technical analysts use RSI in conjunction with other technical indicators, fundamental analysis, and business cycle analysis. Consider using multiple indicators along with RSI, such as support and resistance, moving averages, and moving average convergence-divergence (MACD), to confirm the signals sent by RSI. That way, you'll have more evidence to support your analysis, potentially resulting in better trades.
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