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Understanding Stock Options Trading
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Relative Strength Index ( RSI ) |
Relative Strength Index ( RSI )
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The Relative Strength Index, or RSI, is a leading
indicator, in that it can predict a stock's price
movement before it happens. This is because the
RSI is a momentum indicator, and indicates overbought
(price is too high) and oversold (price is too low)
conditions. In overbought conditions, the price
of the stock is bound to retreat and stabilize in
the near future. Similarly with oversold conditions.
Whereas moving averages are based on a stock's closing
price, the RSI is based on gains and losses. Basically,
the number and size of gains and losses are used
to calculate the relative strength for a particular
period, say a 14-Day period. Subsequent relative
strengths are then used to plot the RSI chart.
The RSI is an oscillating indicator, fluctuating
between 0 and 100, where 0 is the most oversold,
and 100 is the most overbought. 50 is the centerline.
Anything above 70 is considered overbought, and
anything below 30 is considered oversold. While
this 70/30 levels are more common, some investors
do use 75/25 or even 80/20 levels to mark overbought
and oversold conditions. These levels will confirm
overbought or oversold conditions much better, but
are less sensitive to normal price movements. For
example, a stock in a trading range might never
hit the 80 or 20 levels, and we will miss out on
all signals.
While the RSI can tell us when a stock is overbought
or oversold, its true value is its ability to indicate
when the stock is coming out of overbought or oversold
conditions, ie. when the stock is going to move
back towards the moving average. So the points to
watch are those when the RSI moves below 70 from
above, or moves above 30 from below.
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Click
here to view a larger updated version of the chart
at Stockcharts.com
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In
the chart above, the RSI crossed below 70 in March,
and again in June. It also crossed above 30 in May.
Therefore, we would implement bearish strategies
in March and June, and bullish strategies in May.
Note that the RSI produced signals days (even more
than a week) before the 20-Day EMA did in the chart
above. This is due to the fact that the RSI, being
a momentum indicator, is a leading indicator and
can predict price movement before it happens.
However, this might not be a good thing, as can
be seen in March. The RSI produced a bearish signal
a month before the actual downturn happened. In
the world of options trading, a month is a long
time.
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The RSI
is a momentum, oscillating
and leading indicator. It is used
to indicate when a stock comes off
its overbought or oversold
conditions. A stock is overbought at RSI values
above 70, and oversold at values
below 30.
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Similar
to the MACD, we can also plot positive and negative
divergences with the RSI. A positive divergence
is when the RSI makes valleys or troughs that get
higher and higher, and indicates a potential upturn.
A negative divergence is when the RSI creates peaks
that become gradually lower, and indicates a potential
downturn.
For example, in the chart below, the RSI formed
a negative divergence in January 2004. This is despite
the fact that the actual stock price was making
higher peaks. Sure enough, the negative divergence
correctly predicted a sharp price drop in early
February.
If we extrapolate further, we can see that after
January, the RSI was forming lower and lower peaks
all the way till June. This is a very bearish sign.
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Click
here to view a larger updated version of the chart
at Stockcharts.com
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We
have only touched on a few of the basic techniques
involving RSI. There are other methods of reading
RSI charts, and are beyond the scope of this guide.
We have to mention again that individual indicators
should not be used on their own, but rather with
one or two additional indicators of different types,
in order to confirm any signals and prevent false
alarms.
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The RSI
can also contain positive and negative divergence
patterns. A positive divergence
predicts future upturns, while
a negative divergence predcits
future downturns.
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| All stock options trading
and technical analysis information on this website is for educational
purposes only. While it is believed to be accurate, it should not be considered
solely reliable for use in making actual investment decisions.
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© 2004-2008 Option Trading Guide. All rights reserved. |
