How does it feel be wealthy? While you may just be average or even on a lower rung of the economic ladder when compared to your neighbors, truth is, you are wealthy.
In fact, the typical person in the bottom 5% of the U.S. income distribution curve is still wealthier than 68% of the world’s population, per the New York Times. Think about that for a minute!
I can hear many you asking what this has to do with the topic of the article?
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It drives home the point that everything is relative. This means that nearly everything in life can only be judged in relation to something else. Wealth, success, and even beauty are merely relative concepts.
Not only is the concept of relativity critical for understanding the world and how it works, it is crucial when evaluating stock market investments.
Stocks are best analyzed on a relative basis rather than as a snapshot of price.
This idea led to one of the most effective technical analysis indicators ever created. This indicator is called the Relative Strength Indicator or RSI.
The Relative Strength Indicator or RSI is an oscillating momentum indicator.
I realize that sounds like a mouthful, but it is really simple. Let me explain, it means that the indicator moves between two extremes on a chart hence oscillates. The RSI’s purpose is to verify if a stock is overbought or oversold.
The indicator is called Relative Strength because it compares increasing price movement to decreasing price movement within a specific time frame. In other words, it uses price as it relates to itself as a decision-making tool.
Fortunately, the RSI indicator is built into most brokers technical analysis platforms and is available for free on websites such as stockcharts.com.
The way it works is that the numbers are plotted as a line on a chart, oscillating between 0 and 100.
If the line moves to 30 or below the stock is considered “oversold”, 70 and above I believed to mean that the stock is “overbought”.
The decision making concept behind the overbought and oversold levels is very simple.
When the RSI moves into oversold territory, it means that all the sellers have already sold therefore the stock is ready to start climbing in value.
On the other side, when the RSI moves into the overbought region, it means that all the buyers have already piled into the stock signaling that it is time to sell.
The way it looks in formula form is RSI is the ratio between the upward and downward price moves normalized into a value that falls between 0 and 100.
The equation for RSI is 100-100/(1 + (total gains/n)/(total losses/n). N is the total number of RSI periods.
The standard number of periods is 14 to calculate RSI. However, a relatively unknown study has revealed another number to be superior to 14.
Before we get into this little known RSI “trick”, let’s look at the traditional way RSI is used.
As in most thing technical analysis related, a picture is worth a million words.
As you can see on the chart below, RSI is plotted on a graph beneath the price graph with a fixed, horizontal line at 30, 50 and 70. 50 is the center line, readings above this line indicate that the gains on average are greater than the losses on average reflecting bullishness.
Readings sub 50 indicate a bearish bias as the down moves are greater than the up moves on average.
Look again at the above chart. Observe the RSI following the price of the stock. Witness how the RSI moves into the oversold area and price starts to climb higher. At the same time, observe the RSI hitting an overbought reading and price falling.
RSI is often displayed behind price on the chart. My experience has been that the majority of traders find this an easier way to view the signals. Here’s an example.
The Three Most Common RSI Patterns
- The RSI hits a lower bottom while price lifts to a higher bottom.
This type of pattern usually occurs in an uptrend after price corrects from a sell off. In other words, price bounces from the lows. When the RSI hits a lower bottom and price sets a higher bottom it means that the uptrend or bounce from the lows will likely continue higher. This is a trend continuation signal meaning that the investor should stay long.
- RSI and price both hit lower or higher bottoms at the same time
This pattern is also a continuation pattern. The uptrend will likely continue higher just like the example above. Traders should remain long after observing this pattern.
- The RSI creates a higher bottom while price moves to a lower bottom.
This pattern is usually seen at the end of an uptrend. It is a reversal pattern meaning that the upward trend is expected to soon end. Traders would be wise to close the long positions or reverse short.
All this can be wrapped up by stating that price will likely move higher if there is a divergence between price and the oscillator. In addition, if price and the RSI bottoms converge in an uptrend, the uptrend is likely to continue.
By using Relative Strength, stocks can be compared with each other so you can choose the strongest performing stocks of the group.
How To Use The RSI To Find Stocks
It’s just not my experience that proves the value of Relative Strength. Several noted academic style studies have reached the same conclusion.
One example of this was recorded by James P. O’Shaughnessy, in his “What Works on Wall Street,” book. James follows a 46 years of stock market history. His study makes clear that Relative Strength significantly outperforms the broad stock market.
Since 1932, the research shows that by using Relative Strength, one can beat the market by just under 4% on average annually.
The Secret To The Relative Strength Indicator
Back in 2005, a market researcher named Larry Connors did the definitive study on the Relative Strength Indicator. What he discovered will likely surprise you. I know the result were very surprising to me.
What Larry discovered is that if the RSI periods are reduced to 2, rather than the standard 14, a statistical edge existed.
The way Larry did the testing was first to build a benchmark of the average percentage gain/loss of all stocks, trading above their 200-day Simple Moving Average, over a 1 day, 2 day, and 1 week timeframe.
What was statistically proven was that the lower the 2 period RSI, the better the performance against the benchmark. In addition, the opposite also proved to be true. The higher RSI(2), the higher the underperformance against the benchmark.
How can this information be put to practical use to help your short term investing?
Scan for stocks with an RSI(2) of 2 or less for short term longs. If you are seeking companies to short, apply the opposite logic by only considering shares with an RSI(2) reading of 98 or above.
Do not be afraid to experiment with the RSI setting to discover one that is optimal for your favorite sector and time-frame.