So the question was…Which stock to pick after seeing the price movement and RSI?
Before we plunge into the answer, let’s learn a bit about RSI.
RSI stands for Relative Strength Index. It is a momentum indicator. It indicates the pace of price moving in a particular direction. It is calculated based on the prior 14 candle’s average gain vs average loss. So, if in look back period, the price moved higher then the RSI reading will move higher, and vice versa.
Because of mathematical capping, RSI moves in between 0 to 100.
Yes, you thought right….if the stock moved from 100 to 1000….still RSI will not cross above 100. Hence, it is called a range-bound indicator.
Utility of RSI
Well, RSI is a versatile indicator with various use but two basic utilities are
1. Overbought/Oversold
2. Positive Divergence/ Negative divergence
in this note, we are going to cover …what is Overbought/Oversold and read the valid signals.
As RSI is a 0 to 100 range-bound indicator, so upper range like 70 to 100 is considered an overbought zone, and 30 to 0 is an oversold zone.
RSI moves down when the price falls. When the RSI reading drops below the 30 level, it indicates a substantial decline in price. It is considered an oversold zone. It is interpreted as buying opportunity as the price has become dearer.
RSI moves up when the price rises. When RSI is above 70 level, it indicates a substantial rise in price. It is considered an overbought zone. It is interpreted as a selling opportunity as the price has become costlier.
But, It is not the case, every stock below 30 is a buy opportunity and a sell opportunity above 70. We need some process to weed out bad signals.
Let’s get back to our quiz. As both stocks are below 30, which stock to choose?
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Stay tune…
here is one point to note...Always look at the oscillator along with price movement.
Have you ever seen it? Cart before the horse.
In our context, the price is the horse and the oscillator is a cart. So, always look at the price first.
In our quiz, Stock A is in an uptrend, and Stock B is in a downtrend. Positive trending stock entering an oversold zone has better strength as compared to stock entering an oversold zone in a negative trend. Stock can remain in an oversold zone for a long time in a negative trend.
So, Stock A has more advantages than Stock B in terms of a reliable buy signal.
Let’s understand with real charts
Gland pharma Daily Chart
This stock is under a negative trend. RSI has entered numerous times in the oversold zone but pullbacks were not significant. Prices continued to move down in spite of being oversold. In our Quiz, it is like Stock B.
VBL Daily Chart
Stock is under strong positive movement. Whenever stock has entered into an oversold zone, it has resulted in a good buy opportunity. In our Quiz, it is like Stock A.
In a nutshell, stock entering an oversold zone due to an intermediate decline can be considered a buying opportunity, and stock entering an overbought zone in a relief rally can be considered a selling opportunity.
