How Does Relative Strength Index Help in Stock Trading?

by Diane Perez

J. Welles Wilder developed the Relative Strength Index (RSI) in 1978. It is a mathematical calculation that tracks the price movement of a designated stock for a specified period, usually the previous 14 days. The RSI values are plotted on a graph so traders can see the high and low selling points. The high and low points are part of the formula to calculate a stock’s RSI.

Relative Strength Index

RSI is a short-term indicator of the future performance of a designated stock. The index ranges from 0 to 100 points. The lower 50 points indicate a bear market trend while the upper 50 reflect a bullish market trend. A bear market trend is when a stock, or the market as a whole, is dropping in price. A stock increasing in price is bullish. Although stock traders generally use a 14-day period, sometimes they choose 9, 11 or 25 day periods. Periods shorter than 14 days are considered as more volatile. To calculate RSI, use the formula: RSI = 100 – (100/(1 + RS)). RS is the average price gain divided by the average price loss for the chosen number of days.

Predictive Value

Stock traders evaluate RSI, along with other indicators, when deciding whether a stock has reached its peak or lowest price. They refer to a stock nearing its peak price, an RSI of 70 or higher, as overbought. It means that minimal profit is available, since traders earn a profit by buying low and selling high. Conversely, a stock nearing the bottom, with an RSI of 30 or lower, has been oversold. If the stock has not dropped due to dire financial straits, then traders prefer to place buy orders in this lower price range.

RSI Divergence

Divergence occurs when the price of a stock goes either laterally or in the opposite direction of the relative strength index. If the stock has been oversold, then traders will place orders when divergence occurs. It indicates that the downward trend has reversed, and the stock is beginning to increase in value. Traders might have difficulty selling stock that is on a downward trend. They usually try to sell just before the peak, when people are still buying.

Centerline Crossover

Another part of the relative strength index that helps stock traders is centerline crossover, an index score of 50. When below 50, traders assume that a stock’s average losses exceed its average gains. The opposite scenario applies when RSI is above 50. When centerline crossover occurs, stock traders might choose price points for buying or selling.

About the Author

Diane Perez is a writer who contributes to various websites, specializing in gardening and business topics, and creates sales copy for private clients. Perez holds a Bachelor of Science in education from the University of Miami.

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