Trader Toolkit: Under The Hood Of One Of The Most Popular Technical Indicators

With more and more trading platforms and the growing allure of low-to-no-fee brokerages, new traders are confronted with a deluge of options when it comes to trading and investing. But lost in the promises of sleek interfaces and free shares for signing up is the fact that successful trading takes time, practice and an understanding of resources experienced traders use on a daily basis.

With that in mind, we’re going to use this new series of articles to take a look at the charts, ratios and indicators that play an integral role in how traders generate ideas and form convictions on their medium- or short-term trades. To do that, we’ll be using the charts and tools available on the Webull trading app, which offers traders access to real, zero-commission trading in addition to a suite of advanced trading analysis and charting.

Relative Strength Index

Despite how straightforward the compounds are, the terms “overbought” and “oversold” are two of the most heavily abused terms among traders and market pundits. However, depending on the previous few weeks of trading activity, those claims may or may not always be accurate. This imprecise usage is a shame since the words have concrete definitions that indicate how a piece of equity might likely behave should it become either overbought or oversold.

To determine whether a piece of equity is, in fact, experiencing an outsized degree of buying or selling, traders rely on something called the Relative Strength Index, or RSI, a technical indicator that gauges the overall resilience of a stock based on its recent closing prices, typically over the 14 periods.

Calculating RSI is a multi-step process that first requires finding the average gain and average loss in the closing prices over a given period (μG, μL). The next step is to divide the average gain by the average loss and add one to this quotient. Finally, divide 100 by that result and subtract that result from 100, which result is the stock’s current RSI. The equation for RSI looks like this:

RSI = 100 - 100 / 1 + (μG / μL)

Since the only variables are the average difference in positive and negative closes, the disparity in those results affects the final calculation, which is measured on a scale of zero, representing heavy selling, to 100, which indicates heavy buying. It’s rare for most stocks to reach the extreme ends of the index, but the area below 30 is generally viewed as oversold territory and the area above 70 is considered overbought.

While knowing the calculation is important, stock charts like the one below from trading platform Webull will often incorporate an RSI reading below a price chart. Here’s an example of the RSI number playing out in this 6-month chart for Amazon.com, Inc. AMZN.

Chart courtesy of Webull

This longer-term chart, the periods of which measure daily changes, shows the blue RSI line hewing closely to the overall price action in the stock. Since Amazon has seen strong price performance and minimal selling, it’s RSI has spent a good deal of time in overbought territory.

From a purely technical standpoint, this might suggest to traders that Amazon’s price has been bid up excessively. In that case, it would be better to wait for periods of selling before jumping in, like occurred early June when the stock briefly peeked into oversold territory.

Although chart symmetry like the example above is common, RSI can be more reactive and less tied to price. Discrepancies between price and RSIdo happen, and they often indicate points at which price may pivot. Below are some examples of this in the 5-minute chart for Netflix, Inc. NFLX.

Chart courtesy of Webull

One of the clearest signals in the above chart occurs in the spots where RSI spikes right before an extended period of selling.

However, less obvious cues, like the bullish formation in oversold territory that occurred on the July 15 session, or the wavering RSI in overbought territory at the start of the July 16 session could both be read as signals that price was about to reverse.

It’s good to pay attention to moments of divergence between a stock’s price and RSI, or when RSI tests its periods of over-extended buying and selling. While stocks can spend long periods as either overbought or oversold, the market is always trying to find an equilibrium somewhere in the middle.

Webull is a content partner of Benzinga