In this instalment of our educational series, Indicator Insights, we shift our focus to the Relative Strength Index (RSI), exploring a non-traditional approach that harnesses its power to identify strong momentum stocks.
While the conventional use of RSI is often associated with overbought and oversold conditions, our alternative method employs RSI as a relative strength indicator, uncovering stocks exhibiting high levels of relative strength.
Understanding RSI - The Traditional Approach
The RSI is a momentum oscillator that measures the speed and change of price movements. Traditionally, traders use RSI to identify overbought and oversold conditions. The standard interpretation suggests that a stock is potentially overbought when the RSI surpasses 70, indicating a potential reversal or pullback. Conversely, an RSI below 30 might suggest that a stock is oversold, hinting at a possible upward reversal.
A Different Perspective - RSI as a Relative Strength Indicator
Our alternative approach views RSI as more than just an overbought/oversold signal generator. Instead, we leverage it as a relative strength indicator, pinpointing stocks that exhibit robust momentum compared to the broader market. The strategy involves waiting for an RSI reading to reach +75, signalling significant strength, and then strategically entering a position during a pullback when the RSI retreats to 50.
Methodology: Buying Strong Momentum Stocks
Identifying Strong Momentum (RSI +75): Monitor stocks with RSI readings reaching +75, indicating robust upward momentum.
Waiting for the Pullback (RSI 50): Exercise patience and wait for the RSI to retreat to 50. This pullback suggests a temporary cooling-off period in the stock's momentum.
Strategic Entry: Initiate a long position when the RSI starts to move back above 50, anticipating a potential resumption of the strong upward trend.
Advantages of This Approach:
Potential Limitations:
Worked Example 1: Buying RSI Pullback on Daily Timeframe
Let's illustrate this approach with a practical example:
Stock: Tesco (TSCO)
Tesco (TSCO) Daily Candle Chart
Past performance is not a reliable indicator of future results
Worked Example 2: Buying RSI Pullback on Hourly Timeframe
Stock: Apple (AAPL)
AAPL Hourly Candle Chart
Past performance is not a reliable indicator of future results
Summary:
This non-traditional use of RSI as a relative strength indicator offers traders a simple way of identifying and capitalising on strong momentum stocks. By waiting for RSI to reach +75 and strategically entering during a pullback to 50, traders can align with stocks exhibiting exceptional strength relative to the broader market.
Disclaimer: This is for information and learning purposes only and is intended for UK audiences. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance. Social media channels are not relevant for UK residents.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.
While the conventional use of RSI is often associated with overbought and oversold conditions, our alternative method employs RSI as a relative strength indicator, uncovering stocks exhibiting high levels of relative strength.
Understanding RSI - The Traditional Approach
The RSI is a momentum oscillator that measures the speed and change of price movements. Traditionally, traders use RSI to identify overbought and oversold conditions. The standard interpretation suggests that a stock is potentially overbought when the RSI surpasses 70, indicating a potential reversal or pullback. Conversely, an RSI below 30 might suggest that a stock is oversold, hinting at a possible upward reversal.
A Different Perspective - RSI as a Relative Strength Indicator
Our alternative approach views RSI as more than just an overbought/oversold signal generator. Instead, we leverage it as a relative strength indicator, pinpointing stocks that exhibit robust momentum compared to the broader market. The strategy involves waiting for an RSI reading to reach +75, signalling significant strength, and then strategically entering a position during a pullback when the RSI retreats to 50.
Methodology: Buying Strong Momentum Stocks
Identifying Strong Momentum (RSI +75): Monitor stocks with RSI readings reaching +75, indicating robust upward momentum.
Waiting for the Pullback (RSI 50): Exercise patience and wait for the RSI to retreat to 50. This pullback suggests a temporary cooling-off period in the stock's momentum.
Strategic Entry: Initiate a long position when the RSI starts to move back above 50, anticipating a potential resumption of the strong upward trend.
Advantages of This Approach:
- Relative Strength Focus: By emphasising relative strength, this strategy aims to align with stocks demonstrating a sustained and potent upward trend compared to the broader market.
- Disciplined Entry: Waiting for the RSI to retreat to 50 provides a disciplined entry point, reducing the likelihood of entering trades during extended periods of overbought conditions.
- Momentum Confirmation: Combining RSI readings with a pullback strategy helps confirm the sustainability of the stock's momentum before entering a position.
Potential Limitations:
- False Signals: As with any strategy, false signals may occur, especially in volatile markets. Traders should exercise caution and consider additional factors in their decision-making process.
- Market Conditions: This method may perform better in trending markets and may be less effective in choppy or sideways conditions.
Worked Example 1: Buying RSI Pullback on Daily Timeframe
Let's illustrate this approach with a practical example:
Stock: Tesco (TSCO)
- RSI Reaches +75: RSI for Tesco reaches +75, signalling strong momentum.
- Pullback to RSI 50: Tesco experiences a pullback, and RSI retreats to 50.
- Strategic Entry: A long position is initiated as the stock shows signs of resuming its strong upward trend and RSI turns back above 50.
Tesco (TSCO) Daily Candle Chart
Worked Example 2: Buying RSI Pullback on Hourly Timeframe
Stock: Apple (AAPL)
- RSI Reaches +75: Hourly RSI for Apple reaches +75, signalling strong momentum.
- Pullback to RSI 50: Apple experiences a pullback, and RSI retreats to 50.
- Strategic Entry: A long position is initiated as the stock shows signs of resuming its strong upward trend and RSI moves back above 50.
AAPL Hourly Candle Chart
Summary:
This non-traditional use of RSI as a relative strength indicator offers traders a simple way of identifying and capitalising on strong momentum stocks. By waiting for RSI to reach +75 and strategically entering during a pullback to 50, traders can align with stocks exhibiting exceptional strength relative to the broader market.
Disclaimer: This is for information and learning purposes only and is intended for UK audiences. The information provided does not constitute investment advice nor take into account the individual financial circumstances or objectives of any investor. Any information that may be provided relating to past performance is not a reliable indicator of future results or performance. Social media channels are not relevant for UK residents.
Spread bets and CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 75% of retail investor accounts lose money when trading spread bets and CFDs with this provider. You should consider whether you understand how spread bets and CFDs work and whether you can afford to take the high risk of losing your money.