Understanding momentum is crucial to becoming a successful trader.
It helps you assess how strong a stock’s move really is. And just as importantly, momentum shifts can warn you when a move is losing steam and at risk of reversing.
One of the key technical indicators I use to gauge momentum is the Relative Strength Index (RSI).
The RSI helps identify when a stock has become overbought or oversold and could be vulnerable to a reversal. That’s why the RSI is a cornerstone of my mean reversion strategy.
So today, let’s take a look under the hood to see how it actually works…
The RSI is calculated by measuring the average size of upward price moves over a set number of periods (typically 14 days). It divides that by the average size of the down moves over the same time.
The RSI then converts the result into a number between 0 and 100. Below 30 typically means a stock is oversold, while above 70 signifies that it’s in overbought territory.
You can see how it works in the chart of Bank of America (BAC) below…
Bank of America (BAC)
Source: e-Signal
When the RSI goes into overbought territory (red circles), you can see that BAC has topped out and retraced lower.
And when the RSI has gone into oversold territory (green circles), BAC has bottomed out and then started to rally.
It’s not an exact science. But you can imagine why traders find this information so useful.
They can exit trades when momentum is starting to dry up. And using a mean reversion strategy, they can spot opportunities when momentum reverses direction. For example, they might open a short trade when the RSI reverses lower out of overbought territory (red circles).
The key point with the RSI is that it helps us identify a potential change in direction. And we can exploit that to help deliver us profits.
Typically, the RSI is set at 14 periods. That means 14 days on a daily chart or 14 weeks on a weekly chart, for example.
However, as you get more advanced with your trading, you can fine-tune the RSI to better match your trading style and the asset that you’re trading.
For example, if you’re trading something volatile like a commodity or crypto, you can increase the RSI time periods from 14 to 20, for example. This averages out the price moves over a longer period of time, so it can take some of the excess volatility out of the RSI. That means it will show fewer false signals.
The other thing you can adjust is the overbought and oversold levels. Some traders might use 80/20 instead of the standard 70/30 levels. Again, the aim is to reduce false signals.
The key is to test out any combination on the chart to see what works best for the product you’re trading and your preferred time frame.
The RSI is a great tool to help identify potential changes in direction. That helps you avoid buying into a stock just as a move fades out. And it can also set you up to capture a potential reversal.
That’s why it’s a key plank with my mean reversion strategy.
And because the RSI is chart-based and not driven by emotion, it can help take the stress out of your trading… and increase your chances of success over the long term.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict
Reading Trading With Larry Benedict will allow you to take a look into the mind of one of the market’s greatest traders. You’ll be able to recognize and take advantage of trends in the market in no time.
