From Keith Harwood, OptionHotline.com
Today seems like a good day to review the RSI.
The RSI, or relative strength index, is a good indicator of when markets are overbought or oversold. But it’s also a great indicator of when a bear market may be done with a short-term bounce, or a bull market is done with a minor pullback.
Before I get into the levels of the RSI I’m watching, let’s review the calculation for the RSI.
The RSI formula is a bit complicated, so I will break it into two pieces: the Relative Strength and the Relative Strength Index:
The number of trading days that the industry traditionally uses, and therefore I use, for calculating this is 14 – this allows for a smooth calculation with enough recent trading days to be significant. This Relative Strength factor tells us how much stronger up days are than down days. And this is a key input to the RSI calculation:
What we see here is that the index helps to scale that Relative Strength parameter and give us something tradeable. The idea here is that when the RSI is over 70, the market is overbought. When the RSI is below 30, the market is oversold.
But, when I look at the market today, we’re simply not getting to 70 or more for an overbought condition. When in a bear market, it’s unlikely to see that kind of level. And in a bull market, it’s unlikely we will see under 30. So, what’s the current “overbought” level? Let’s look at SPY and see what we can figure out:
Recently, a very neutral RSI of 50 has been a tough level to breach, and that seems natural in a bear market – we are unlikely to get to 70, but 50 shows the market back to neutral, and in a bear market, neutral is about as good as it gets. On the downside, 30 has been difficult to breach. Perhaps this can help us get a better idea of our trading range as we look for opportunities to buy or sell.
If the market gets back into a bullish trend, we will have a lot of work to do in crossing moving averages, changing the RSI range, and of course changing the price range. At the end of the day, the RSI can be another great tool for indications of where we may look to stall to the upside or downside as we work through this difficult chopping market. It’s great to have a lot of tools in the toolbox, and the RSI is one of my favorites.
If you’d like to learn more, please go to http://optionhotline.com to review how I traditionally apply technical signals and probability analysis to my options trades. As always, if you have any questions, never hesitate to reach out.