How to Determine Market Breakouts by Relative Strength Index (RSI)

Summary: How to determine the market has a fake or authentic breakouts, the Relative Strength Index (RSI) can answer the question. The main idea is to see if the RSI reaches the overbought (70) status again, the price surpasses the previous high.

The current secular bull market started from March 2009. After long periods of price appreciation, investors need to make their own intelligent judgment to decide what to do with the hefty profit.  They might take their bulky profit and leave the game anticipating the market may turn the direction. Or, they might expect the well-founded direction to keep intact, and buy more securities at breakout.

However, it is challenging to determine if the new trend will emerge or the market will maintain the existing trading range.

To answer this tough question, the Relative Strength Index (RSI) might provide some insight, since it is capable of normalizing daily price data, and providing improved description about the actual price movements by smoothing the reading.

The RSI is intended to gauge the velocity (speed with positive or negative direction) and movement magnitude for the entire stock market, or individual stocks.

Investors can adopt the RSI as the stochastic indicator to enter or exit trading.  The Relative Strength Index is used to measure the degree of oversold or overbought equities in the stock market. Once this technical indicator is overbought, and curls downward towards breaking out of the overbought territory, it might be a good idea to exit the market or stocks.

On the other hand, the RSI can be applied to confirm the breakout for the general market or individual stock.

Here are some steps to distinguish the authentic versus fake breakout:

Step 1: If the RSI crosses over a 70 reading, and breaks resistance, the market or share price reaches a new high as well.  This might be a good indication for market breakout.  You might observe the market movement for a couple days to get confirmation.

          In December 2012, the market reached overbought status, and the RSI was over 70. After the market had consolidated for a while, the RSI reached 70 again, and passed the previous RSI reading. Moreover, the Dow Jones Industrial Average surpassed the previous level significantly by exceeding about 1,000 points. It was a positive indication of a breakout.  The market gained the momentum since then, and made a record high on 8/1/2013. 

Step 2: Usually in strong trending markets, the underlying securities might make a confirmation by pulling back slightly. Then you can watch: when prices fall back, if the RSI is holding up, and is higher than the previous RSI reading. 

          Step 3: Set a reasonable stop loss just in case of the false break-out, otherwise, enjoy the free ride for profit.