Relative Strength Index (RSI): Here’s how investors can use it to their advantage

One of the simplest technical indicators that investors can employ is the Relative Strength Index (RSI). How does it work and how can investors use it to their advantage?

What is the RSI?

The Relative Strength Index (RSI) is a technical indicator that compares the magnitude of recent gains to recent losses in a stock’s price. It is calculated as a ratio between positive and negative average price changes, usually over the past 14 days. The RSI ranges from 0 to 100, with higher readings indicating strong buying momentum, while lower readings indicate strong selling pressure. As a general rule, a stock with an RSI over 70 is considered over-bought while a stock with an index under 30 is considered over-sold.

The RSI can be a useful tool for investors as it helps them assess whether a security is currently overbought or oversold, allowing them to make more informed trading decisions. By analysing both historical values and current values of the RSI, investors can identify potential reversals in trend direction before they occur. This allows traders to maximise their profits while minimising their exposure to risk by entering into positions at opportune times.

An example

Take a look at Cettire (ASX:CTT) and its share price in the last few years. You can see that the RSI has roughly followed the share price. A period of a low RSI in the first half of 2022 was followed by a significant upswing. There was a pullback the couple of times when the metric went over 70. Come 2024, and the bad news impacting the stock this year led to a massive sell off. And when the RSI went below 30, shares slowly started to rise again, but of course it is a long way to go for the company to reach its previous highs.

Cettire (ASX:CTT) share price chart, log scale (Source: TradingView)

How to use it to your own advantage

Investors can use the Relative Strength Index (RSI) to their advantage by making informed decisions about when to buy and sell stocks. By taking into account the RSI, investors can make more informed decisions regarding when to buy or sell a stock. Considering a stock with a reading below 30, some investors may consider it a buying opportunity if and when the trend reverses.

Obviously, it is about catching the stock as it enters an uptrend again. If the downtrend continues, they can lose money. It is important to consider why a stock is oversold in the first place and whether or not those factors might either reverse or disappear. The same applies in relation to stocks that are overbought. Some investors may take it as a shorting opportunity, thinking the trend must reverse. If correct, you make money, but if you are wrong, you lose money.

And of course, as the example of Cettire shows, the metric becomes irrelevant when good or bad news comes and the share price suddenly moves in one direction.

The key is to use it with other indicators

In both instances, the RSI only helps you identify a potential opportunity. It is insufficient to determine the exact direction the stock will go and when exactly a trend reverses. The index’s reliability and accuracy increases when used in conjunction with other technical indicators. This helps to gain a more comprehensive understanding of the current market conditions, providing better insights for informed trading decisions. The key is to identify when a stock has broken out of a downtrend or is in a new uptrend.

Furthermore, different technical indicators often provide unique signals that can complement one another and lead to improved trading results. Therefore, while the RSI can be effective when used on its own, its use should ideally be combined with other indicators as part of an integrated approach to trading.

Overall, the goal is to identify these potential reversal points in a stock’s movement. By doing so, investors can make more informed decisions regarding when to enter or exit positions in order to take advantage of potential profits.

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