Financial news media oftentimes makes a big deal of key Dow Jones Industrial Average levels, like 10,000, 14,000, and most recently 17,000. But many traders watch SPX (the S&P 500 Index) more closely.
With .SPX approaching a key technical price level, the relative strength index (RSI) is one tool you can use to determine whether stocks might break through 2,000 or face resistance over the short term.
How we got here
While stocks haven’t rallied at a gangbusters’ pace as they did last year, it’s been a steady march higher for most of 2014. SPX 2000 is now within striking distance, as positive macroeconomic fundamentals have outweighed geopolitical turmoil and other cautionary risks (see the graphic below for some examples).
During July, stocks appear to have settled into a range between 1,960 and 1,985. Like other momentum oscillators (a type of technical indicator that fluctuates in a range, usually between 0 and 100), RSI is most helpful in non-trending markets—where the stock, index, or other security’s price is fluctuating in a range between two prices.
If SPX has indeed settled into a range below 2,000 while investors determine whether stocks are ready to surmount this widely accepted, significant technical level, RSI might be particularly useful. The index is threatening to breach and hold above the top of the July range, hitting 1,987 on July 24, 2014.
The relative strength index is one of the more widely used technical indicators, mostly because of the relatively simple, straightforward signals that it generates. It is scaled from 0 to 100 and is used primarily to determine whether a stock or other security is overbought or oversold. The chart below shows typical placement of RSI beneath a price chart, using SPX as the example.
Investors using RSI generally stick to a couple of simple rules. First, low RSI levels, typically below 30 (the red horizontal line in the RSI section of the chart above), indicate oversold conditions—generating a potential buy signal. Conversely, high RSI levels, typically above 70 (the blue horizontal line in the RSI section of the chart above), indicate overbought conditions—generating a potential sell signal.
As of July 24, 2014, RSI is closer to overbought territory, registering a reading just above 60—a value that does not generate a clear trading signal. Active investors may want to monitor what happens in the next several days. If RSI were to rise to 70, that would generate a short-term sell signal, based on RSI rules. Alternatively, if RSI were to fall to 30, that would generate a short-term buy signal.
One tip to consider is that the trading signals generated by RSI are typically most valid to the user when values reach an extreme reading near the upper or lower end of the boundaries. Thus, a sharp move in RSI near 100 (the top of the RSI scale) would be strong evidence of overbought conditions (a sell signal), while a sharp move in RSI near 0 (the bottom of the RSI scale) would suggest oversold conditions (a buy signal). Obviously, SPX is not currently near either extreme.
If RSI does move off its current level to either above 70 or below 30, that would generate a primary overbought or oversold signal. However, it’s important to realize that it is not unusual for the indicator to remain in overbought or oversold territory for an extended period of time (weeks or even months). This should be intuitive: recall that RSI is most valuable to the user in non-trending markets, so a trending market where the underlying security is in a sustained uptrend or downtrend—resulting in RSI not generating primary trading signals because it is staying above 70 or below 30—would render RSI less useful. 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.
In a related note, the longer SPX remains in a non-trending market (i.e., in its current trading range below 2,000), the more valuable RSI signals may become.
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.
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, occurs when the 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 occurs when RSI forms a higher high, but the price forms a lower high. This would be a bearish move, generating a sell signal.
Looking at the SPX chart above, there do not appear to be clear positive or negative reversals recently. The most recent clear RSI low is the July 17 reading of 50, when the SPX was at 1,958. If RSI makes a subsequent low below 50, watch whether SPX closes above 1,958 for evidence of positive reversal (a bullish sign). On the other hand, if RSI makes a subsequent high above the most recent (63 on July 16), see whether SPX closes below the price of that day (which was 1,981) for evidence of a negative reversal—a bearish signal.
Another tool that a technical analyst might consider using is volatility bands around the RSI oscillator. If you are familiar with the Bollinger Bands® technical indicator, which plots above and below the price of the underlying security, you know what volatility bands look like. Volatility bands plotted around RSI can be used to generate buy and sell signals as well.
The key to using this method is to look at the upper and lower extreme ranges for RSI. At extreme highs, a sell signal might be generated if the RSI line fails to touch the upper band when the RSI line is near it. Alternatively, at extreme lows, a buy signal might be generated if the RSI line fails to reach the lower band.
RSI in action
Most technical analysts use RSI in conjunction with other indicators. 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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