A key to weathering – and potentially profiting from – a market correction is planning and implementation.
A Tool That Can Help You Time Your Trade
Every trader would love to own a crystal ball that can tell when the time is right to invest in a stock, or when it’s time to exit. Though it’s not a perfect crystal ball, the Relative Strength Index (RSI) might be able to offer a gauge of momentum in a security. Essentially, it’s measuring the rate of the movement in the price of a security.
“The RSI is a popular indicator that traders can use to help determine whether they should enter or exit a position,” said Brian Bachelier, vice president of active trader strategy for Scottrade.
How the RSI Works
Often employed as part of a broader trading strategy, the RSI is an average of a stock’s gains and losses over a specific period of time – often 14 days, which makes it a short-term indicator. The RSI assigns a value to a stock between 0 and 100. Typically, a stock is considered overbought when its RSI rises above 70 and it is oversold when it falls below 30.
The RSI can be flexible, however. You can use shorter or longer than 14 days depending on the security or your own trading strategy. In addition, some traders use more extreme RSI triggers than 70 and 30 to offset the possibility of getting a false signal that can come with large, sudden price movements. For example, you may choose to set your trigger limits at 80 and 20, which would automatically delay any trading decisions.
“The interesting part of the RSI is that traders can alter it to suit their trading plan and their comfort levels,” Bachelier said. “It’s as robust as you want to make it.”
In the figure above, the top graph represents movement in a stock price, while the black line below represents the RSI line. The red and green lines at the bottom are RSI triggers.
How RSI is used in trading
At its core, then, the RSI gives traders an orderly way to determine when to trade a security. For example, when the stock or index is trending directionally the RSI can be used as a guide to enter trades on short-term countertrend movements that occur against that trend. In other words, an oversold extreme on the RSI could set up a possible buy entry on a pullback in an uptrend.
Limitations of the RSI
The RSI can give misleading signals when a security’s price is trending strongly, with the indicator remaining at overbought or oversold levels for long periods of time. In these instances high or low values for the indicator actually affirm the trend rather than setting up countertrend entry points.
“The most important thing to remember is that the trend is your friend,” said Bachelier. “The trend is primary. RSI is a secondary indicator that helps you determine entry and exit points.” By following trends, Bachelier said traders are better able to forecast future direction of a stock’s price.
Next steps: If you’re an eligible Scottrade client, check out ScottradeELITE, which can help you with your trading decisions.
The content provided is for informational and/or educational purposes only. The information presented or discussed is not, and should not be considered, a recommendation or an offer of, or solicitation of an offer by, Scottrade or its affiliates to buy, sell or hold any security or other financial product, or an endorsement or affirmation of any specific investment strategy. You are fully responsible for your investment decisions. Your choice to engage in a particular investment or investment strategy should be based solely on your own research and evaluation of the risks involved, your financial circumstances, and your investment objectives. Scottrade, Inc. and its affiliates are not offering or providing, and will not offer or provide, any advice, opinion or recommendation of the suitability, value or profitability of any particular investment or investment strategy.
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