Get Strong with Relative Strength Index (RSI)

Hey There Income Hunters,

When laying out my game plan for stock plays, you will often see me reference the Relative Strength Index (RSI).

 

It’s an awesome technical indicator that helps me measure the bullish/bearish direction and momentum of an asset … and it can also help predict highs, lows and trend reversals.

 

RSI is often plotted below an asset price graph as it oscillates between 0 and 100. (We have J. Welles Wilder to thank for that. He’s the analyst who developed RSI in the late 1970s.) Check it out here:

 

 

Interestingly, RSI accomplishes this by measuring the relative strength of price against itself.

 

RSI is often plotted below an asset price graph as it oscillates between 0 and 100. (We have J. Welles Wilder to thank for that. He’s the analyst who developed RSI in the late 1970s.)

 

Default values for oversold/undervalued are 30 and 70, respectively, on a 100-point RSI scale, though those thresholds can be adjusted to your liking when analyzing a particular stock. 

 

Calculation

A quick note on how Relative Strength Index is calculated …

 

Relative Strength (RS) = average gains over a period of time  / average losses over a period of time.

 

The formula to calculate Relative Strength Index (RSI) is: 100 – (100 ÷ (1 + RS))

 

For example, if the relative strength of a security over the average RSI calculation period of 14 days is 40 and the average loss is 20, your equation would look like this:

 

100 – (100÷(1+40÷20)) = 66.66

Divergences

One of my favorite features of RSI is that it can be used to signal a potential reversal in a trend via divergence, which indicates a lapse in price momentum.

 

A divergence occurs when there’s a disagreement between price and RSI. In an uptrend, the price will make higher highs but the indicator will not. It’s the same in reverse for a downtrend, as the price will make lower lows but RSI does not.

 

While both indicators are either traveling upward or downward simultaneously, the RSI is beginning to diverge from price.

 

Below you’ll see an example of both a bullish and bearish divergence:

 

Divergence indicates that the current price trend is running out of steam …

They can be helpful in giving insight that you should close out a profitable trade or give you a signal to play for a reversal of trend.

Questions about that? Feel free to email me anytime!

Example Stock

When you have a favorite stock that has a defined trading range, meaning sideways action between support and resistance, RSI can be an especially great trading tool …

 

AT&T is a prime example …

 

As you can see in the chart below, AT&T trades between $25 and $50, so it gives you even more confidence when you get an RSI divergence signal near those areas.

 

The signal allows you to be more aggressive since those are the outer bounds of the stock in general…

 

 

It’s simplest use is to put bearish trades on when the stock is overbought, meaning RSI is above 70, and buy when it is oversold, when RSI is below 30

 

To improve your chances, avoid buying or selling when you get a signal in the middle of the larger trading range, see the blue circle in the previous chart. 

 

You know you may be in the middle of a trend by looking back and seeing how the stock reacted when it was previously in the zone of the RSI signal.

 

The blue circle shows that previously AT&T came from lower and rallied right through the area you are getting the signal. This gives you an alert that it may not stop on the way down either.


Bring It Home
I like to use RSI because it is a forward looking technical indicator.

When you jump on a divergence, it’s near a price extreme, so you know quickly if it is going to work, or you simply get out for only a small loss.

Enjoy your week guys and always …

Live and Trade With Passion My Friends,

 

Griff

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