The RSI, or Relative Strength Index, is a momentum oscillator that attempts to show overbought or oversold conditions within a financial market. The oscillator has a range from 0 to 100, with levels above 70 indicating a possible overbought condition while levels below 30 could potentially indicate an oversold condition.
While the standard setting for the RSI is 14 days or periods, the index can be adjusted for both larger and smaller time frames. The index can even be used on an intraday basis, such as with a 5 minute candlestick chart.
Here is a very simple strategy that may be utilized for long stock entries. For example purposes, we will discuss use on a daily time frame, however, the strategy can also be employed on larger or smaller time frames and even intraday:
Step 1: Identify a stock you’d like to be long that is trending higher on the daily and weekly time frames.
Step 2: Using the 14 day standard setting, examine the RSI on the daily chart and wait for a reading of 30 or lower to be registered.
Step 3: Place a buy stop order just above the previous day’s high.
Step 4: If the buy stop is triggered, place a stop loss just below the previous day’s low.
Step 5: Manage the position.
The idea with this type of strategy is to look to enter a stock on a pullback within an uptrend. Just because the stock may decline and register a 30 or lower reading on the daily RSI, does not mean the uptrend is over. Stocks don’t typically go straight up or straight down and even in a strong uptrend the market will likely see some pullbacks on profit taking if nothing else.
You’ll notice that this strategy looks to enter a long position using a buy stop. The strategy does not attempt to buy the low of the pullback or move. Markets can and do remain oversold for long periods of time. By waiting to buy until the stock makes a move above the previous day’s highs, you are essentially waiting for some confirmation of strength and a possible continuation of the longer-term uptrend. Rather than trying to catch a falling knife, you are simply looking to get long once the selling appears to have been exhausted.
If the uptrend is in fact strong, the stock may recover quickly and significantly from an oversold RSI reading on a pullback. By waiting for a potential oversold condition to develop, you can buy the stock at a more favorable level and possibly enjoy a good ride if it resumes an existing uptrend.
