Momentum traders tend to follow trends and look for stocks trading higher or lower on heavy volume to maximize their potential gains. They’re not focused on fundamentals or news looking instead to profit from price action. Some momentum traders use the Relative Strength Index or RSI to compare the magnitude of a stock’s rise or fall over a specified time period. Here’s how this indicator is used:
What Is Relative Strength Index?
The relative strength index quantifies the speed at which a stock’s price changes. Consequently, the RSI provides traders with an idea of when a stock is overbought or oversold.
Before using the RSI, it’s important to know how to read relative strength index and apply the information to your own personal trading strategy. Generally, traders use the 70 and 30 levels in the RSI to determine whether a stock is overbought or oversold, respectively. If the RSI falls below the 30 level, the stock is considered to be in oversold territory. Conversely, if the RSI rises above the 70 level, it indicates that the stock may be overbought.
Here’s an example of the RSI in action on Facebook Inc. (FB):.
In this annotated chart, notice that FB found some support after the stock was in oversold territory. Thereafter, the stock and the RSI began to trend higher, ultimately becoming an indication that the stock was poised to reverse, after it formed a bottom and built momentum to the upside. That said, once the RSI rose significantly above 70, the stock hit some resistance and pulled back to the uptrend line, indicating that another reversal in trend could be in the offing. This relative strength index formula shows how FB could trend, making it an appealing option for investors who follow this trading strategy.
The relative strength index can indicate reversals in trend, and can confirm when stocks are building momentum. Generally, you want to see the RSI trend higher in the 30 to 70 level, coupled with an uptrend in price, to indicate the stock is building momentum to the upside. The opposite is true when you’re looking for an indication of a stock picking up speed for a fall.
Petra Hess runs PetraPicks.com. She is a technical swing trader and long-term investor in domestic and Canadian stocks and ETFs.