Relative Strength Index may hold clues for the end of a trend.
Growing up in the Midwest, kids learn very quickly the difference between a tornado watch and a tornado warning.
A watch means that conditions are right for a tornado to form, but one hasn’t been spotted yet. A warning means head for the coal cellar because tornados are spinning nearby.
Technical analysis indicators like the Relative Strength Index (RSI) can act as watch signals for stocks, giving investors a heads up that although things appear normal, potential changes may be coming soon.
What It Says
The RSI compares average prices of days when the stock closes higher with days where the stock closes lower. The RSI line will rise and fall with the stock price in between a range of 0 and 100. When the RSI line rises above 70, the stock is considered to be “overbought,” meaning that its price might be a little overextended on the high side. In other words, “tornado watch” conditions are present, and those who are fans of this indicator may suspect a downward move may not be too far off. In the opposite scenario, the RSI line falls below 30 and this indicator considers the stock to be “oversold.”
The most significant use of RSI is when the indicator’s trend is not moving in the same direction as the stock price. This is called a divergence and some investors see this as indication that the stock’s trend may be weakening.
Take a look at the recent example of the S&P 500 (SPX) in Figure 1. Around March 19, 2012, the RSI line peaked above 70 (that’s considered overbought by this particular indicator), which was followed by a lower peak on March 26. At the same time the price of SPX was making higher peaks, so it was diverging from the RSI. This is like the tornado watch: conditions may be building for a potential change.
FIGURE 1: RELATIVE STRENGTH INDEX (RSI) Looking to enter or exit a long-term stock position? RSI is one indicator that might help you answer the question “When?” by assessing the strength of the trend. Source: Penson Worldwide, Inc. For illustrative purposes only. Past performance is not a guarantee of future results.
How Traders Use It
All technical indicators have their admirers and detractors; here is how fans of RSI see it. If your portfolio closely tracks the performance of a major index like the S&P 500, they look for a break above or below the index’s trend line following the RSI’s divergence. In Figure 1, SPX’s break of support came about one week after the divergence was spotted. In the case of a break below support, traders might think about protecting their portfolio. Some wait to create bearish positions anticipating a trend change as early as the first lower peak on the RSI; others may wait for the index to break below a further support level.
Sometimes trading can seem like trying to tame a tornado, but many traders like to watch an indicator like RSI, to help them consider when a watch might turn into a warning.