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 the relative strength index (RSI), which measures the speed and change of price movements. This measurement is intended to evaluate the relative value of a stock—based on its recent price history. Out of all the technical indicators there are, RSI is one of the more commonly used due to its relative simplicity.
In recent weeks, RSI has held steady below the overbought indicator line that would suggest a sell signal. If RSI were to increase slightly from where it is now, that would generate a short-term sell signal, based on RSI rules.
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. Using the S&P 500® Index (.SPX) as a proxy for the broad market, you can see in the SPX chart that large-cap stocks have been trending higher since late June. However, the pace of advance has slowed in recent weeks with the market at all-time highs.
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, 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).
This chart shows the 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.
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. For example, when the market plunged in late June due to the Brexit vote, RSI fell as well, dropping near the 30 level—a potential buy signal. The market rebounded soon after.
One tip to consider is that the 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, 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). As the SPX chart shows, RSI is not near extreme levels in mid August.
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.
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.
In recent weeks, RSI has not made lower lows or higher highs. Instead, it has made lower highs (e.g., 64 on August 5, compared with 66 on July 20) as the market has trended higher; this does not generate a clear trading signal based on commonly used RSI rules. However, if RSI were to subsequently make higher highs, while the price of the S&P 500 were to begin making lower highs, that would be a negative reversal and additional evidence of a bearish sell signal.
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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