The Relative Strength Index (RSI) is a widely used technical indicator that measures the magnitude of recent price changes to determine overbought or oversold conditions in a stock. Developed by J. Welles Wilder Jr. in 1978, RSI has become an essential tool for traders and investors seeking to identify potential buy and sell signals.
What is RSI?
RSI is a momentum oscillator that calculates the average gain of up days and the average loss of down days over a specified period, typically 14 days. The resulting value is then plotted on a scale from 0 to 100.
Relevance of RSI
RSI is relevant for several reasons:
- Identifying Overbought and Oversold Conditions: RSI helps traders detect when a stock is overbought (above 70) or oversold (below 30), indicating potential reversals.
- Confirming Trends: RSI can confirm the direction of a trend, providing additional confidence in trading decisions.
- Generating Buy and Sell Signals: RSI can be used to generate buy and sell signals based on its crossovers with the 30 and 70 levels.
How to Use RSI
To effectively use RSI, follow these steps:
- Choose a Time Frame: Select a time frame that aligns with your trading strategy, such as 14 days for short-term trading or 28 days for long-term investing.
- Set the RSI Levels: Set the RSI levels to 30 and 70, which are the traditional thresholds for oversold and overbought conditions.
- Identify Divergences: Look for divergences between the RSI and the stock price, which can indicate potential reversals.
- Monitor Crossovers: Monitor the RSI for crossovers with the 30 and 70 levels, which can generate buy and sell signals.
Adding RSI to Thinkorswim
To add RSI to Thinkorswim, follow these steps:
- Open Thinkorswim: Log in to your Thinkorswim account and navigate to the Charts tab.
- Select the Stock: Enter the stock symbol you want to analyze.
- Click on Studies: Click on the Studies button at the top of the chart.
- Select RSI: Select RSI from the list of available studies.
- Customize the RSI: Customize the RSI settings, such as the time frame and levels, to suit your trading strategy.
Making Stock Trading Decisions with RSI
To make informed trading decisions using RSI, follow these guidelines:
- Buy Signal: When the RSI falls below 30 and then rises above it, consider buying the stock.
- Sell Signal: When the RSI rises above 70 and then falls below it, consider selling the stock.
- Confirmation: Always confirm RSI signals with other technical and fundamental analysis tools to increase confidence in your trading decisions.
- Risk Management: Set stop-losses and position sizes based on your risk tolerance to minimize potential losses.
Example Trading Scenario
Suppose you’re analyzing Applied Materials (AMAT) using RSI on a 14-day time frame. The RSI falls below 30, indicating an oversold condition. You notice a bullish divergence between the RSI and the stock price, suggesting a potential reversal. As the RSI rises above 30, you consider buying AMAT. You set a stop-loss at 5% below the entry price and a position size of 2% of your portfolio. This happens to be exactly what I did today.
Notice the grey circles I drew below. The bottom section is the RSI chart. The yellow lines within the RSI chart indicate the 70-30 levels. As mentioned, RSI alone is not how a decision to buy or sell a stock should be made. But for me, it is one of the ways a stock gets my attention either to research buying it if it’s oversold, or to research selling it if it’s overbought.
Conclusion
The Relative Strength Index (RSI) is a powerful technical indicator that can help traders and investors identify potential buy and sell signals. By understanding how to use RSI, adding it to your trading platform app e.g. Thinkorswim, and incorporating it into your trading strategy, you can increase your chances of success in the stock market. Always remember to confirm RSI signals with other analysis tools and practice risk management to minimize potential losses.
