Charts: Using relative strength to guide stock decisions
The relative strength index or RSI is a widely used technical tool which measures the size of recent price movements to determine whether a stock is overbought, and in danger of correction, or oversold and maybe about to rebound.
Technically the RSI is an oscillator rather than an index, as it oscillates between zero and 100. It can never go below zero, nor can it read more than 100.
In the long run, the RSI is a mean-reverting series – when it is too high (overbought), it reverts downward, and when it is too low (oversold), it reverts upward again. However, stocks can stay overbought or oversold for considerable periods of time once they are in a trend.
– A value of 70 or more is considered overbought
– A value of 30 or less is considered oversold
The standard period for calculating the value of the RSI is 14 trading days, although high-frequency traders use a much shorter period.
To find the RSI using the charting function on Shares’ website, click on the Settings cog, choose Events & Indicators, and scroll down to Relative Strength Index. The period will automatically default to 14 days.
For this example, we use the chart of insurer Direct Line (DLG) over a one-year period, with candlesticks rather than a simple line chart.
The first thing that strikes us is how orderly the RSI history is, topping out precisely at 70 and bottoming at 30 each time.
Historically, each time the RSI has hit 70 it has been a reliable selling opportunity, and each time it has hit 30 it has been a buying opportunity, which is a rare occurrence.
Once in a trend many stocks can stay overbought or oversold for months on end. However, a sign to look for in an overbought stock is what is known as ‘negative divergence’.
Negative divergence: Although the shares may be making new price highs, below the surface the RSI is falling.
Conversely, the sign to look for with an oversold stock is ‘positive divergence’.
Positive divergence: Where the price is making new lows but behind the scenes the RSI is no longer making lows and is instead heading upward.
As always when it comes to stock picking, technical indicators are no substitute for rigorous analysis and due diligence, but with a few small, easy-to-use tools the small investor can at least give themselves a better picture of a company’s share price behaviour.