How to Profit from the Stock Market by Applying Relative Strength Index (RSI)

People usually argue about how to make money in the stock markets.  The most popular answers would be, “buy low to sell high”, or “buy high to sell higher”.  Nonetheless, the financial market could rise from high to higher, or plunge from low to lower. It is difficult for investors to detect the highest levels or lowest levels.  Thus, investors might lose trading opportunities, or leave too much profit on the table. The Relative Strength Index (RSI) is helpful for traders and investors under this circumstance.

The general conditions of the stock market can be categorized into two classes as trending and range-bound market, which can be determined by stock market movement. In a range-bound market, the general market or stocks waver between the major resistance and support, without breaking out of the existing channel. A trending market usually has apparent trends, either uptrend or downtrend.

When the stock market goes up, the RSI rises accordingly. No matter how strong the market is, and how long the RSI stays in the overbought status, the market eventually takes a breath, and experiences profit taking. Then, the RSI swings or approaches to an oversold territory.

If investors always buy at oversold and sell at overbought, they will certainly make money in an uptrend or range-bound market.  On the other hand, if they sell or short at overbought, and buy at oversold conditions, they will be a winner in a downtrend stock market. The key is to determine market trend.

In general stock market, five primary factors may impact the stock market movement.  They are corporate earnings, Federal Reserve influence, the world situation, investor sentiment and confidence, and supply of liquidity.

We do not want to give you the wrong idea. The market does not necessarily go down once it has entered the overbought status.  In a bull market, the RSI tends to stay in a range between 50 and 80.  Depending on how strong and robust the market is, the RSI can stay in overbought status for many days.  From 5/3 to 5/21/2013, the RSI (5) stayed in range 73 to 85 for 13 consecutive trading days. Until the FOMC minutes showed that some of the Fed members were willing to curtail the asset purchases as early as June this year, the market took a breather on 5/22/2013. 

When the RSI falls to 30 or below, the market or a stock is defined as oversold, and the price of shares might be deemed to rebound in the near term.  When the market was turbulent, for example, during the financial crisis 2007-08, the RSI usually stayed between 20 and 50.  From 2/10/2009 through 3/9/2009, exactly a 1 month period, the RSI ranged from 9 to 43. Most days, during that time period, the RSI stayed in oversold territory.  Until 3/10/2009, the Dow Jones Industrial Average gained 379 points. The market direction was reversed, and the Dow Jones Industrial Average rose from the multiple years’ low of 6,456.  

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