Use This 'Unknown' Indicator to Accumulate Profits

It's incredibly important for investors to have a solid set of tools to help evaluate potential investments. Otherwise we're just following what other people say without using our own brains - a sure-fire way to lose money. Independent investors need to think for themselves, and act according to their own research. 

Technical analysis methods blended with fundamental research is the best combination of tools. Over the next couple of weeks I'll review a number of technical analysis tools that you can use to help time your buy and sell decisions.

Today we'll take a look at the relative strength indicator (RSI). The relative strength of a stock is a measure of a stock's price against its past performance. It helps to determine the internal strength of the stock.

It's a very easy indicator to turn on when using most finance charting websites such as Yahoo! Finance or StockCharts.com. On Yahoo! Finance, use the 'interactive chart' feature and look in the drop-down tab for 'technical indicators'. You can set the RSI to the period of your choice. Note that it will be in the same period as the one you select for your chart, days for a daily chart, weeks for a weekly chart, or minutes for a minute chart. I suggest sticking with 14 days and 3-month, 6-month, and one year charts until you become accustomed to using the index. 

RSI is a technical momentum indicator that quantifies the magnitude of gains and losses to determine whether the stock is overbought or oversold. The formula for relative strength is: RSI = 100 – (100 / (1 + RS)). In this formula, RS = (average of (x) days up closes) / (average of (x) days' down closes).

The RSI of a stock is useful only when the relative trend is observed over a period of time. The scale is set from 1 to 100, and when RSI rises to 70, it indicates that the stock could be getting overbought. Conversely, if the RSI drops below 30, the stock could be getting oversold and you may want to accumulate shares. The appeal of this barometer is that it enables you to apply a simple formula to draw a meaningful conclusion about the price strength of a single stock.

Take a look at the three month chart of Green Mountain Coffee Roaster GMCR below. This stock has been selling off and rallying due to fundamental reasons, but the RSI indicator has been fairly accurate in signaling when the stock should rise (RSI hits 30) and fall (RSI hits 70).

A key momentum indicator, the RSI can be used to time entry and exit decisions based on momentum. For example, a stock that has a low, but improving, RSI may begin to show signs of strengthening stock price. Momentum investors may see this change as an early sign that the stock is going to outperform the market in the future.  

Another advantage to using RSI is that it can be calculated over any time period. Very short-term traders may track RSI over just a few minutes, whereas traders willing to wait for longer time periods may want to use RSI over several months. As I mentioned earlier, start with using a 14-day period on 3-month, 6-month and one year charts and go from there depending on your preference. 

The key change in RSI, represented by strengthening or weakening trend lines or even crossover points (with other indicators like moving averages), is believed by many technicians to anticipate more specific signals like breakouts and strong price reversals. RSI, accompanied by observation of changes in the patterns of trading ranges and resistance or support tests, can serve as an important early indicator of new trends in a stock's price.

But be careful, the more indicators you use the more confusing things can become when first starting to use technical indicators. Ease into it by adding one, then two indicators and you'll learn faster than adding everything all at once. 

All technical indicators are generalizations, and none by themselves can be used reliably to make specific trading decisions. They can be used to confirm emerging fundamental trends in a company's ever-changing competitive stance. The best approach to studying a company is utilizing a wise combination of fundamental and technical indicators, and tracking both types over a period of time.

Just like most things, understanding technical analysis measures like the relative strength indicator takes practice. But to a trained eye, RSI can give the astute investor an idea where the stock price may go. Practice before you act, and gain confidence. You'll be glad you did when you start to make profitable investments and trades.

I've been using the RSI indicator to help time entry points for Small Cap Investor PRO recommendations. Right now our last seven recommendations are up an average of 46.4 percent, and two have returns over 100 percent! Click here to learn more, and find out why small cap stocks ALWAYS outperform.