Technical indicators are useful for predicting stock trends’ direction. These indicators are derived by applying a formula to the stock price. The commonly used technical indicators are the Relative Strength Index (or RSI), stochastics, the Moving Average Convergence Divergence (or MACD), and Bollinger Bands.
Relative Strength Index
The RSI is a measure of a stock’s overbought and oversold position. The commonly used RSI is a 14-day RSI. It refers to the 14-day stock price that’s used to calculate the RSI. The number of days used to calculate the RSI can vary.
The above chart shows the RSI and stock price movement for General Motors’ (GM) stock.
The RSI calculation is shown below.
RSI = 100-100/(1+RS*)
*RS = Average gains/average losses
For a 14-day RSI, the stock’s 14-day price movement is used to calculate average gain and loss. If the stock’s price increased for the first ten days and decreased for next four days, the stock’s price decreased.
Average gain = sum of absolute gain in ten days/14
Average loss = sum of absolute gain in four days/14
The RSI moves between zero to 100 levels. It’s normalized using the formula RSI = 100-100/(1+RS*).
When the stock’s price decreases for 14 days in a row, the RSI will show zero values. It indicates that the stock is oversold. When the stock’s price increases for 14 days in a row, the RSI will show 100 values. It indicates that the stock is overbought. The level of 30 is considered oversold. The level of 70 is considered overbought.
When the stock is oversold and at the support level, it could be used as an entry point. When the stock is overbought and at the resistance level, it could be used as an exit point. It isn’t recommended to use the RSI indicator alone for an entry and exit strategy. It’s advisable to use a combination of indicators and patterns for entry and exit signals.