One of the most popular tools in technical analysis that is used to predict a shift in a stock's momentum is known as the relative strength index (RSI). This indicator's primary purpose is to determine when a given rally is becoming overbought or oversold. Generally speaking, readings below 30 suggest that the stock has been pushed to an unjustifiably low level, causing most bullish traders to start looking for a strategic entry position. On the other hand, readings above 70 are often used to suggest that the rally is getting exhausted and that the bears may be getting ready to send the stock lower.
The indicator is plotted between a range of zero to 100 where 100 is the highest overbought condition and zero is the highest oversold condition. The RSI helps to measure the strength of a security's recent up moves compared to the strength of its recent down moves. This helps to indicate whether a security has seen more buying or selling pressure over the trading period.
The standard calculation uses 14 trading periods as the basis for the calculation which can be adjusted to meet the needs of the user. If the trading periods used is lowered then the RSI will be more volatile and is used for shorter term trades. (For more, see Ride The RSI Rollercoaster)
How It Is Used
As mentioned above, the most common method of applying the RSI is to use overbought/oversold lines to generate buy-and-sell signals. In the RSI, the overbought line is typically set at 70 and when the RSI is above this level the security is considered to be overbought. The security is seen as oversold when the RSI is below 30. These values can be adjusted to either increase or decrease the amount of signals that are formed by the RSI. Let's take a look at a few stocks that have recently entered overbought territory because these could be candidates for a short-term pullback when the broad market rally ends.
Advance Auto Parts Inc. (NYSE:AAP)
CSX Corp. (NYSE:CSX)
Corrections Corporation of America (NYSE:CXW)
Diageo Plc. (NYSE:DEO)
eBay Inc. (Nasdaq:EBAY)
The RSI is a standard component on any basic technical chart and is a great method of filtering stocks that could be setting up for a short-term pullback. In most cases, traders will want to confirm any buy or sell signal by using other technical indicators or chart patterns to increase the probability that a predicted move will actually occur. (For more, see Relative Strength Index Helps Make The Right Decisions)