- Relative strength is often used to signal when a stock is oversold
- Contrarians may use relative strength measures to buy into oversold shares
At the core of many technical strategies is the notion of contrary thinking, or going against the crowd. Many sentiment measures and studies exist, often focusing on the behaviors of various groups of investors such as options traders, or small investors, or newsletter writers, and so on.
The idea is also seen in many so-called “oscillators,” technical indicators that swing back and forth between extremes, signaling when a stock has become “overbought” or “oversold,” the implication being that if it’s overbought, you might be late to the party.
One such indicator is RSI, or the Relative Strength Index. It measures a stock’s price strength today relative to the stock’s price over the previous 14 days. It is said to express the momentum in the price of the stock.
The essential idea is that an overdone stock in any direction often indicates price pressure in the other direction as the enthusiasm in the overbought stock dissipates, or the bearishness of an oversold stock lessens. But there are other ways to use RSI, including one particular short-term strategy sometimes called “RSI is wrong.”
RSI says what?
RSI is calculated from the price range for the stock. The formula results in a value that has a range of 0 to 100, with a stock being characterized as overbought if RSI is 70 or higher, and oversold if RSI is 30 or lower. Surely the term oversold seems to suggest an opportunity to buy, and overbought says sell, right? Not necessarily!
Some traders look for high momentum stocks—those rising in price persistently—for short-term trades, and it turns out that using a high RSI as an entry signal can be productive. The idea is to take a closer look at the stock when it crosses into overbought territory—that is to say, when RSI crosses up through 70. These trades that can last for a week or two, and a look at the chart for Cisco Systems CSCO shows the idea in action.
RSI is plotted below the price display by the green line that swings up and down. The 70/30 lines are visible, and the shaded area highlighted shows where RSI rose above 70, registering an overbought condition.
Source: Power E*TRADE
The first period was from February 15 to February 28 when a nimble trader could’ve picked up a 4-5% gain as the stock moved from the 49 area to over 52. Then RSI signaled again on March 11 with the stock around 51.50 and moved as high as 54, and then once more, putting in a move from around 54 to 57.52, a jump of 6.5%
So, the strategy is simple. Stocks that have just moved above RSI-70 could be worthy of consideration for a week or two, provided the rest of the chart makes sense. These are by definition very short-term trades. Know that over-extended stocks can reverse very quickly, and some do for sure!
On Target for overbought territory?
One stock that currently satisfies these conditions is Target (TGT). With the stock near 89 and within striking distance of new high above 90.39, a break-out move could hold RSI above 70 for several days, offering an opportunity for jack-be-nimble-quick traders.
Just keep in mind that past performance is not indicative of future returns, and trade strategies do not always translate into results.
Source: Power E*TRADE