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Using the Relative Strength Index to Your Advantage


It may be more versatile than you think.

The Relative Strength Index (RSI) measures a stock's or index's strength relative to its own price history. This is different than the more general use of the term "relative strength," which refers to the measurement of a stock or index relative to another stock or index, usually the S&P 500.

In its basic use as an overbought and oversold indicator, the overbought level is above 70 and the oversold level is below 30. These levels are often adjusted by technicians based on the history of the specific security, the type of market (trending or choppy), and the time frame being traded.

The overbought and oversold signals are most valuable when combined with other RSI signals. One such signal is called the failure swing, which is identified on the chart below. It happens when the RSI closes above 70 (point 1 on the chart), retraces, then pokes above 70 again but doesn't take out the old high (point 2 on the chart). The pattern is complete when the lower peak's trough breaks below the trough following the higher peak (point 3 on the chart). If this occurs while the RSI is diverging from price, as it is in this chart, it's an even stronger and more reliable signal. Once the signal is triggered, it remains valid as long as the RSI reading stays below 70.

Click to enlarge

Another signal, when combined with an oversold RSI reading, is divergence. When the RSI peaks above 70 and subsequent lower peaks follow, diverging from a rising price, it's usually an indication that the trend is waning and a turn is near.

Most oscillators and momentum indicators diverge from price at the same time. For example, at the same time the RSI on the chart above was diverging from new price highs, the chart below (which I posted on the Buzz & Banter on October 13 -- subscription required) shows very pronounced divergences between price and the MACD and Momentum indicator.

Click to enlarge

Notice that I drew trendlines on these indicators. A breakout through the trend line on the RSI (or other oscillator) can be interpreted in the same manner as the breakout of a trendline of price. Drawing a trendline on the RSI is a useful way for you to confirm breakouts in price: A breakout of the RSI before price is usually followed by price. A breakout of price that isn't confirmed by the RSI often fails.
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No positions in stocks mentioned.

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