The RSI is a leading indicator that measures the overbought and oversold condition of a stock by tracking the changes in its closing price. RSI is plotted between 0 and 100, with 30 as the default oversold line and 70 as the default overbought line. When the RSI line dips beneath 30 and then crosses back up above it, that represents
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an oversold condition that is about to bounce. When it extends above the overbought 70 line and then crosses beneath it, that marks an overbought condition that is about to sell off.
When calculating the RSI, use the formula:
where RS equals the average of net up closing changes for a specific number of days, divided by the average of net down closing changes for the same number of days. The common default number of days used is 7.
The right way to use the RSI for bullish signals is:
1. If prices make a new low, but the RSI does not confirm that low and instead makes a higher bottom, cover shorts or go long. This indicates bullish price divergence.
2. If prices are in an uptrend and the RSI line moves below the oversold 30 line, and then crosses back above the 30 line, cover shorts or go long. This indicates a pullback within an uptrend, and presents the opportunity to reenter the uptrend from the long side.
The right way to use the RSI for bearish signals is:
1. If prices make a new high, but the RSI does not confirm that high and instead makes a lower top, then sell long or go short. This indicates bearish price divergence.
2. If prices are in a downtrend and the RSI line moves above the overbought 70 line, and then crosses back below the 70 line, sell longs or go short. This indicates a bounce within a downtrend, and offers an opportunity to reenter the downtrend from the short side.
The chart in Figure 17-4 shows that EBAY formed a bullish engulfing pattern in the beginning of August with the RSI line crossing above the oversold 30 line for the first time since mid-June. This took place with strong volume and a move above the daily 8-period moving average.
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