The importance of the relative strength index and how to leverage it

The importance of the relative strength index and how to leverage it

May 28, 2020 | 0 comments

Relative strength index is a technique used to measure the price performance of an asset over a certain period of time, usually 14 days. It moves between two conditions: overbought or oversold, showing these two extreme conditions of a certain asset and displaying it as a line, so you can determine whether the asset is trending upwards or downwards. The range is calculated between 0 and 100, where the overbought area is shown in the ratio between 70 and 100, showing that a specific asset’s price has exceeded market projections, and the oversold area is shown between 0 and 30, indicating the opposite. When the Index is in the oversold area, you should look to buy, whereas when it is in the overbought area, it might be a sell signal. 

The relative strength index is considered nowadays one of the most helpful indexes in trading and a necessary piece of data when looking to grow your investment portfolio. Its popularity has risen thanks to research studies and well-known investors who have emphasized its benefits in helping determine when to best buy and sell an asset, based on the likely trajectory of the market. 

Relative strength index is useful when picking bull credit spreads in order to cultivate your investment. A typical RSI in a bull market stays in the 40 to 90 range and between 10 and 60 in a bear market, so you can use RSI as a signal when it moves out of the oversold and overbought area, by generating a buy signal when the indicators crosses above the lower end, and a sell signal when it crosses below the higher end. As a trader, you should look for support for this indicator in a bull market in a range between 40 and 50, and resistance in a bear market between 50 and 60. 

RSI comes in handy when picking covered calls in order to help increase investment income when you don’t believe that the prices of the stocks in your portfolio will rise from their stagnant state in the near future. When looking at covered calls, look for the RSI to be greater than 70. In this sense, you could attain the shares and write an at-the-money covered call that would mandate a sale just above the band. 

Just like with any indicator, you should always keep an eye on the trend when using RSI. If the indicator is moving in a direction opposite the trend, something may happen soon, so watch out. Divergences between the RSI and the price of a stock can act as a warning of a price reversal. Because the Relative Strength Index is constantly moving up and down in a zigzag pattern, identifying divergences can be relatively easy. When you see the price of a stock make a series of lower lows and the RSI do the opposite (higher lows), it may be an indication that the price momentum is changing and spread traders should keep an eye for a change in trend. This is known as bullish divergence. If the price is making higher highs and the RSI is making lower highs, the rally may be losing momentum; something known as bearish divergence. 

Because RSI can indicate the top of the trading range just as well as it can indicate a strong market, the key questions you should ask yourself before relying on RSI is whether this is a range or if the market is trending, and try to sell as near to the top of the range as possible if you determine you are in a range, and try to hold for as long as you can trailing a stop when you determine you are riding the trend.


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