Identify overbought and oversold stocks with RSI

This is an overbought market hence buy only on dips.

That stock is oversold thus it looks attractive at this juncture.

If you are a trader or an investor and frequently watch business channels, you must have heard experts using these phrases quite often.

Many of you might have wondered how they can comment on the overbought and oversold positions with such high conviction.

The answer lies in technical analysis.

Relative Strength Index (RSI)—one of the most frequently used oscillators—helps you identify overbought and oversold positions in a specific stock, sector or an index.

Read further to learn how to identify overbought and oversold stocks on your own!

Since RSI measures the strength of the price momentum with respect to its historical movements, you should always use RSI in conjunction with price charts.

In other words, RSI doesn’t help you understand whether a stock is overbought or oversold as compared to any other stock but it allows you to assess whether it is overbought or oversold vis-à-vis its own historical price trend. Hence, RSI essentially talks about intrinsic technical strengths of a stock or an index and not about the strength of extrinsic factors.

How to calculate RSI?

RSI can be calculated in two steps.

In step one, you should compute average gain/loss for a pre-decided period (usually 14 days).

In step two, size and magnitude of the momentum is smoothened out for the same time period.

The formula for finding RSI value, therefore, is:

(Source: Investopedia, stockcharts)

Decoding RSI further…

With rising frequency and magnitude of average gains, you will get higher RSI reading for the stipulated period and vice-a-versa.

Sometimes, investors get carried away by the magnitude of price movements on price charts, completely ignoring the underlying frequency and accumulation and distribution patterns of the stock. Hence the study of RSI is extremely crucial for traders and investors alike.

Points to remember about RSI

  • RSI is the leading indicator of price movements. In plain English, it foretells a rise or fall in a stock or an index.
  • RSI oscillates between 0 and 100.
  • Usually, a stock moves in an overbought zone if its RSI reading goes above 70, whereas, the reading below 30 gives an indication of it being in the oversold area.

Further explanation…

When the RSI hovers in the overbought zone, it’s an indication that the scrip might lose the upward momentum shortly and the probability of a fall is high. The reverse is also true when RSI hits the oversold zone.

Moreover, you can apply various chart patterns (reversal and continuation patterns) to RSI.  You can also draw a trend line on RSI charts to get breakout or breakdown signals.

(Source: Ventura Securities)

Some practical tips for using RSI indicator more effectively

You shouldn’t treat the reading of 30 and 70 as the biblical confirmation of oversold and overbought positions respectively.

In reality, for an uptrending stock, the RSI moves up and down in the range of 40 and 90 wherein 40-50 zone acts as the support. Meaning, a stock can generate a buy signal even when the RSI is in the range of 40-50 if it is trending up. And sometimes, it won’t generate a sell signal even if the RSI reading breaches 70.

On the other hand, RSI sways in the range of 10 and 60 if the stock is trending downwards. In such cases, 50-60 zone acts as a resistance. In simple language, the rally in the stock tends to run out of steam even when the RSI reading is below 50. And it may not become a buy even when RSI falls to 30.

Therefore, it’s crucial to recognise the established price trend on the charts. You should carefully watch out for reversals as well. Should the price trends change, the interpretation of subsequent RSI readings will also change accordingly.

As depicted in the graph below, Avanti Feeds was in a strong uptrend between November 2016 and November 2017.

If you sold the stock when RSI crossed 70 for the first time in March 2017, you might have repented later, considering the ferocity of the upmove. Conversely, if you got tempted when RSI fell to 28 in June 2018, you would end up buying the stock at Rs 511.

Now the right interpretation:

When RSI touched 70 for the first time, the stock was trading above its trend line and didn’t show any sign of fatigue. RSI too didn’t breach its 9-week average (demonstrated by the red line). RSI and price charts shared harmony. This was a hint that the upmove might continue even in future.

RSI crossed below the average line in June 2017, but the stock was still in the uptrend since it didn’t break the trendline. However, this was a warning signal that the uptrend was likely to become weak in future as RSI and price charts showed divergence.

Eventually, RSI crossed below 70, and the stock also breached its trendline in December 2017 thereby confirming the end of the uptrend. Again, RSI and price charts struck the same chord.

Since then, the stock has been in the firm grip of bears and despite RSI falling down to 30 several times; the stock hasn’t done any better.

When will it turn a corner?

Let’s re-plot the chart and look at it differently.

RSI has resisted breaching the low of 28 repeatedly and in fact, has improved noticeably in recent times. Its crossing above the average line indicates that bulls have now started giving bears a run for their money. But until now, the price chart hasn’t given the confirmation of a change in the primary trend—still no harmony.

In the present setup, if the stock closes above 420 on a weekly basis, that may be construed as a signal to buy.

Avanti Feeds serves as a classic example of why one should have a holistic approach to technical analysis. Same RSI readings can have different connotations when the underlying trade setup is different.

After all, an overcoat is a boon in winter, but it’s baggage in summers. If climatic changes can change your perception, changes in the investment climate can undoubtedly alter it too.

Spotting trends on the price chart and matching them with trends in RSI is the key to identifying attractive entry and exit opportunities using RSI indicator.

PS: If you thought this article helped you learn something new today, we highly recommend you to read MACD Generates entry and exit signals for stock traders. If you start using RSI and MACD indicators in conjunction and to the perfection, you might be delighted to see the results after a while.

PS PS: If you have any specific question about technical analysis or any of the concepts discussed herein, do write to us at blogcontent@ventura1.com. We would be happy to resolve all your doubts.

 

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