RSI indicator suggests stock market caution

The Relative Strength Index (RSI) can help evaluate if a stock or index is over or underpriced.

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Recently, the primary signals given by RSI haven’t provided much direction to investors. But a more advanced reading suggests active investors may want to remain vigilant concerning the value of the market.

RSI in context

At Fidelity, we believe it’s important to start your investment process with a long-term plan that is built upon your individual goals, risk tolerance, time horizon, liquidity requirements, and tax constraints.

We believe security selection 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 basics

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 security is overbought or oversold. It is calculated using the average gain and average loss over a defined period of time (see the full formula here).

Like most other oscillators, it is most helpful in non-trending markets—where the stock, index, or other security’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.

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 technical analysts 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).

Applying RSI

Using the S&P 500® Index ( .SPX ) as a proxy for the broad market, you can see in the SPX chart above that large-cap stocks have been trending higher since late June 2017. However, the pace of the advance has slowed in recent weeks, with the market at all-time highs. From a short-term perspective (i.e., roughly one month), U.S. stocks appear to be in a non-trending market, whereas the longer-term trend is upward sloping.

Currently, RSI sits around 50, 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, based on RSI rules. Alternatively, if RSI were to fall to 20 or 30, that would generate a short-term buy signal. For example, in early March 2017, RSI jumped to 80—registering a potential sell signal. Immediately after that happened, stocks halted their uptrend, and subsequently declined through mid-April.

In early August, stock market weakness drove RSI lower, potentially setting the stage for an RSI buy signal—if it were to fall below 30. However, the market stabilized in mid-August, and RSI has trended higher. If RSI were to continue its uptrend and top 70 or 80, this might suggest that stocks may be overvalued in the short term.

It is worth noting 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.

Advanced tips

In addition to these 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 security (or index, in our case).

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.

RSI and the S&P 500 recently exhibited a version of a negative reversal. While the S&P 500 has continued to make new higher highs, RSI made a lower low (the RSI reading of 37 on August 10 was lower than the previous low RSI reading of 43 on July 6). This could be interpreted as the S&P 500’s rally occurring despite stocks being overvalued, as measured by RSI.

A reading like this would suggest caution, and further attention to other data that might confirm or deny the reversal reading (e.g., the S&P 500 weakening to confirm the bearish negative reversal or RSI making higher highs to confirm the market’s uptrend).

RSI in action

Most technical analysts use RSI in conjunction with other technical indicators, fundamental analysis, and business cycle analysis. Basing trading decisions solely on any one indicator could result in poor analysis.

Instead, 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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