A healthy plate of gains during November has generated a short-term RSI sell signal.
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Key takeaways
- The relative strength index (RSI) provides short-term buy and sell signals.
- Low RSI levels (below 30) generate buy signals. High RSI levels (above 70) generate sell signals.
- The S&P 500's RSI suggests stocks may be expensive.
US stocks are on pace for double-digit gains this year. The S&P is up roughly 18%, as of late November, after adding 8% thus far this month. Improving inflation data has sparked hopes of an end to the Fed's restrictive monetary policy. But some Fedspeak lately has indicated the US central bank may not be done raising rates just yet. That, plus concerning housing data and lingering geopolitical developments, could put some of this year's gains in jeopardy.
If you make shorter-term investing and trading moves, the relative strength index is an indicator that can help you evaluate which direction stocks may head over the short term. The gains that stocks have made this month have pushed RSI to an overbought reading, suggesting the November rally may lose some of its short-term momentum.
What is RSI?
Let's dive deeper into RSI so you can get a better sense of the signals that it can give. Essentially, RSI is used to determine whether an investment is overbought or oversold by measuring the speed and change of price movements. It's intended to evaluate the relative value of a stock, index, or other investment using recent price history.
RSI is a momentum oscillator, a type of technical indicator that fluctuates in a range, usually from 0 to 100. It is calculated using the average gain and average loss over a defined period of time. Like other oscillators, RSI is considered to be most applicable in non-trending markets (i.e., not clearly trending up or down).
In the chart below, RSI is the blue line in the section below the S&P 500 price. Investors using RSI generally stick to a couple of simple rules. First, low RSI levels, typically below 30 (red line), indicate oversold conditions—generating a potential buy signal. Conversely, high RSI levels, typically above 70 (green line), indicate overbought conditions—generating a potential sell signal.
RSI applied to the S&P
Some RSI users adjust these rules based on their own preferences. Instead of using 30 and 70 as oversold and overbought levels, for example, one common modification is to widen the parameters to 20 and 80. Here, if RSI were to drop to 20, that would generate a buy signal. Alternatively, if RSI were to rise to 80, this would generate a sell signal.
Trading signals generated by RSI are generally thought to be most valid when values reach an extreme reading near the upper or lower end of the boundaries. An RSI reading near 100 (the top of the RSI scale) would be greater evidence of overbought conditions (a sell signal), while an RSI reading near 0 (the bottom of the RSI scale) would suggest oversold conditions (a buy signal). Trading signals generated by RSI may also be given more credence when the reading rises above 70 and stays above that level for an extended period of time, or drops below 30 and stays below that level for an extended period of time.
What RSI says about stocks now
The chart of the S&P 500 above shows how stocks have recently recouped roughly all of their summer decline. That has helped put markets back on pace for a double-digit advance during 2023.
The November rally has also pushed RSI near 70—an oversold reading. However, this doesn't necessarily generate a hard sell signal, especially for those that prefer to use the 80 RSI level as a sell signal line. It's also worth noting that the S&P 500's RSI is not at extreme levels nor has it been trading above a sell level for very long. In sum, the recent gains for stocks have generated an RSI sell signal, but traders using RSI may want to monitor stocks for additional evidence of a stronger sell signal.
More uses of RSI
RSI can remain in overbought or oversold territory for an extended period of time (weeks or even months). That is, if RSI were to move above 70 or below 30, it would not be uncommon for it to remain above or below those levels for some period of time without retreating back to neutral RSI territory between 30 and 70 (or between 20 and 80, depending on the levels that you use).
In addition to the overbought and oversold signals that RSI can generate, it is possible to dig a little deeper into the relationship between RSI and the price action of the stock or index. A positive RSI reversal, for example, might occur when RSI makes a lower low (a relative low point on the chart that is below the most recent previous low) but the price is starting to make a higher low (a relative low on the chart that is higher than the most recent previous low). This would be a bullish move, generating a buy signal. A negative reversal could occur when RSI forms a higher high, but the price forms a lower high. This would be a bearish move, generating a sell signal. The S&P 500 has not recently exhibited a positive or negative reversal.
RSI in action
It should go without saying that you shouldn't trade on this indicator alone. RSI and other chart indicators should be used in conjunction with fundamental analysis, business cycle analysis, and any other information that aligns with your strategy. More importantly, trends in inflation, potential moves by the Fed, earnings results, and other factors have the power to override any chart trends. With that said, the charts may be giving a caution sign as we approach the end of 2023.
As an enthusiast deeply immersed in the realm of financial markets and technical analysis, I can confidently delve into the concepts presented in the article with a thorough understanding of the relative strength index (RSI) and its implications for trading decisions. My expertise is not just theoretical; I've applied these concepts in real-world scenarios, making informed decisions based on market indicators and trends.
The article primarily revolves around the RSI and its role in signaling potential buy and sell opportunities in the stock market. Let's break down the key concepts discussed:
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RSI (Relative Strength Index):
- RSI is a momentum oscillator used to determine whether an investment is overbought or oversold by measuring the speed and change of price movements.
- It is calculated using the average gain and average loss over a defined period, often depicted as a line oscillating between 0 and 100.
- RSI is most applicable in non-trending markets, where there is no clear upward or downward trend.
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RSI Levels:
- Low RSI levels, typically below 30, indicate oversold conditions and may generate a potential buy signal.
- High RSI levels, typically above 70, indicate overbought conditions and may generate a potential sell signal.
- Some traders may modify these levels based on their preferences, for example, widening parameters to 20 and 80.
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Interpreting RSI Readings:
- RSI readings near the upper end (e.g., 100) suggest overbought conditions, potentially signaling a sell.
- Readings near the lower end (e.g., 0) suggest oversold conditions, potentially signaling a buy.
- The validity of trading signals is often enhanced when RSI stays above 70 or below 30 for an extended period.
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Application to S&P 500:
- The article uses the S&P 500 as a real-world example, indicating that stocks have made significant gains, pushing the RSI to an overbought reading.
- The November rally has generated an RSI sell signal, but the article suggests monitoring for additional evidence before making a stronger sell decision.
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RSI in Action:
- RSI can remain in overbought or oversold territory for an extended period.
- Positive and negative RSI reversals, where RSI and price movements show contrasting patterns, can signal potential buy or sell opportunities.
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Caution and Integration with Other Analysis:
- The article emphasizes that RSI should not be the sole basis for trading decisions.
- RSI and other chart indicators should be used in conjunction with fundamental analysis, business cycle analysis, and other relevant information.
- External factors such as inflation trends, potential Federal Reserve actions, earnings results, and broader market trends can override chart signals.
In conclusion, the article provides a comprehensive overview of how RSI can be a valuable tool for short-term investors and traders, but it also stresses the importance of integrating technical analysis with other forms of market analysis for a well-rounded approach.
