How Effective Is The RSI Indicator When Trading Stocks?

The RSI technical indicator is one of the most popular technical indicators. It is an oscillating indicator and is generally regarded as being quite effective at signalling overbought and oversold positions, but how effective is it in reality?

Well let me first of all explain how the RSI (Relative Strength Index) indicator provides these signals first of all. You don't really need to know the mechanics of how the RSI is calculated because all you really need to know is that a stock is generally seen as being oversold when the RSI is below 30 and overbought when it is above 70 (although some traders like to use 20 and 80 in order to obtain better entry points).

Of course these signals are not guaranteed to be correct otherwise we would all be millionaires, but it can still be very effective at certain times. It's arguably most accurate when identifying temporarily oversold positions in a stock that's in a nice upwards trend. This is because even stocks that have trended higher for sustained periods of time still have small peaks and troughs, and the RSI acts as a good entry point when it is oversold during an upwards trend.

It works the other way round as well. For instance if you are looking to trade shares and more specifically take short positions, then overbought RSI readings of 70 and above can provide you with a good entry point for trading weak stocks that are in a strong downwards trend.

It should also be pointed out that there are times when the RSI is not so reliable. This is generally when you are fighting against the overall trend. For example the RSI is often a weak signal of an overbought position in a strong upwards trend, and vice versa when there is a downwards trend. You only have to look at the current downwards trend that has taken place this year. Many stocks have been oversold according to the RSI at various times on various stocks, but they have still fallen substantially lower so this was a pretty useless signal in general.

So if you are looking to use the RSI indicator, do not use it in isolation first of all, and if you do use it, you should bear in mind that it's usually most effective at providing good entry points for stocks currently in a strong upwards or downwards trend. You should always be trading with the trend anyway, so the RSI provides you with strong entry points during these trends.

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