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The Relative Strength Index (RSI) is a popular momentum indicator used to signal overbought and oversold conditions. This is achieved by determining the strength of a stock’s recent higher closing prices to the recent lower closing prices. The RSI indicator is plotted on a scale of 0 to 100 with 0 representing the most oversold conditions and 100 the most overbought.

There are two main methods of determining buy/sell signals using the RSI indicator:

• RSI Crossover Levels
• RSI Divergence

Relative Strength Index (RSI) Crossover Levels

Using the RSI to determine overbought and oversold conditions can be achieved when the signal rises or falls below predefined levels. These predefined levels are referred to as crossover levels and typical settings include 70/30 and 80/20. These levels are related to the RSI scale of 0 to 100 and for example with the 80/20 settings, overbought signals are generated when the RSI signal falls below 80 and oversold conditions when rising above 20. Additionally, overbought signifies that a price down-turn may be approaching and conversely a price up-turn after oversold conditions are met.

Using RSI crossover levels for buy/sell signals can be seen graphically in Figure 1, for Microsoft (MSFT) during the 6 months from February 2009. As can be seen there are two buy signals generated when crossing over the oversold level of 20. Two sell signals are also generated over the period when crossing the overbought level of 80.

Figure 1: RSI 80/20 Crossover Levels Example – MSFT

Figure 1 Note: The RSI signal used in the example of Figure 1 has a period of 14 (default settings). Using a low period will generate more buy/sell signals however they may not all be accurate. A higher degree of confidence can be achieved basing buy/sell signals off a longer period RSI.

Relative Strength Index (RSI) Divergence

Divergence is where two signals are trending in opposite directions. A divergence with the stock price and RSI signal can indicate that a stock price reversal may soon occur. RSI Divergence is best illustrated in the example shown in Figure 2 for IBM during the 8 month period from September 2008.

Divergences occurring after a cross over into overbought / oversold conditions are much more reliable that when the RSI is at an intermediate level.

Figure 2: RSI Divergence Example – IBM

Around November 2008 the stock price was in a downward trend setting new lows however the RSI signal during that period was setting higher lows causing a divergence. The mid November price break-out confirmed the improving momentum which saw the stock price continue on an upward trend.

The two months from April 2009 saw a steady trend upwards in the stock price however the RSI was setting new lower highs causing a divergence. The stock price reversal came mid June 2009.

Investing Tip: Look for a confirmation of expected future price trends from one or more indicators before investing.

All charts have been generated using the First Class Trader stock market analysis software.