RSI suggests stocks have room to rise

• 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 suggests the recent rally has room to continue.

Is a Santa Claus rally in store for stocks during the remainder of 2022? US election uncertainty is mostly resolved and recent inflation reports have showed a slowdown in prices for goods and services. Of course, any of the negative factors that have helped push the S&P 500 to be 17% in the red thus far this year could prevent stocks from trying to gain momentum heading into 2023. 

However, since early October, stocks have slowly trended higher. Will the relatively bullish momentum continue? If you make shorter-term investing and trading moves, the relative strength index is an indicator that can help you evaluate which direction stocks may head over the short term. Here's why RSI says investors may have reason to believe there’s room for stocks to push higher.

What is RSI?

RSI measures the speed and change of price movements. It's intended to evaluate the relative value of a stock, index, or other investment—based on its recent price history.

RSI is a momentum oscillator, a type of technical indicator that fluctuates in a range, usually from 0 to 100. RSI is used primarily to determine whether an investment is overbought or oversold. It is calculated using the average gain and average loss over a defined period of time. Like other oscillators, RSI is most helpful in non-trending markets (i.e., not clearly trending up or down).

In the chart below, RSI is the blue line in the section below the S&P 500 price. Investors using RSI generally stick to a couple of simple rules. First, low RSI levels, typically below 30 (red line), indicate oversold conditions—generating a potential buy signal. Conversely, high RSI levels, typically above 70 (green line), 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 greater 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). Trading signals generated by RSI 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.

What RSI says about stocks now

The chart of the S&P 500 above shows how US stocks have moved lower overall this year, but are little changed since mid-June. More recently, stocks have rallied off their 2022 lows to near 4,000. Is this a dead cat bounce or will Santa Claus come early for investors?

RSI has been rising, but it is still below 60 (not near a sell signal). This suggests that stocks are not yet oversold. Additionally, both the S&P 500 and RSI have been making relatively higher highs recently, suggesting that the bullish trend may continue.

Of course, this does not necessarily mean stocks will rise. It simply means that RSI has not given a signal counter to the existing trend. If stocks do push higher, short-term investors and traders could keep an eye on the 80 RSI level as a cautionary sell signal.

More uses of RSI

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 RSI territory between 30 and 70 (or between 20 and 80, depending on the levels that you use).

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 RSI 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

It should go without saying that you shouldn't trade on this indicator alone. Most technical analysts use RSI in conjunction with other technical indicators, fundamental analysis, and business cycle analysis. More importantly, trends in inflation, potential moves by the Fed, the war in Ukraine, and other fundamental factors have the power to override any chart trends. But based on RSI, there's room on the charts for stocks to keep moving higher.