Relative Strength Indicator

Module 5: Technical Indicators

Lesson 4: The Relative Strength Indicator

The relative strength indicator is yet another momentum oscillator that, if used properly, can make investing in stock options worth your while.

It is commonly referred to as the relative strength index, which in fact is its proper name.

I will use the terms relative strength indicator and relative strength index interchangeably, so to avoid confusion just remember that they both mean the same thing.

If you’re new to investing in stock options, you will quickly realize that there are several momentum oscillators you can use.

In my opinion, there is no one indicator that is the best to use.

The key to successfully investing in stock options is to find the indicator or combination of indicators that’s the easiest for you to work with .

After all, most of them essentially show you the same thing.

In this module, I’m only outlining the few I’ve used while investing in stock options. You can either duplicate my efforts or find your own combination. In your search to find the perfect indicator, just remember that a technical indicator, such as the relative strength indicator, is just a tool.

The relative strength index is a tool used to see price action more clearly .

How the Relative Strength

Indicator Works

The relative strength indicator was introduced to me later on in my trading career so I haven’t used it as much as the other two momentum oscillators (Williams %R, and the Slow Stochastics).

Once I got the hang of it I realized that it essentially worked just like any other momentum oscillator.

• It indicates whether the market is moving to new highs, new lows, or is just meandering in the middle
• It uses recent price and volume data to aid in assessing whether a recent change in trend will continue or revert to it’s prior state
• And last but not least, it’s used to pin point overbought and oversold signals

So already I’ve shown you three momentum oscillators that essentially do the same thing. Now your job is to find the one that you like best .

The relative strength index is plotted on a scale ranging from 0 to 100. The magnitude of the stock’s recent price movement (gains vs. losses) is compared and then that relationship is translated into a number ranging from 0 to 100.

The center line for the relative strength index is 50, which is often seen as both the support and resistance line for the indicator.

If the relative strength index is below 50, it generally means that the stock’s losses are greater than the gains. When the relative strength index is above 50, it generally means that the gains are greater than the losses.

Remember though, we are speaking in terms of price momentum. Is the momentum increasing in the up direction, or is the momentum increasing in the down direction?

Momentum measures the rate of the rise or fall in stock price .

Here is a way to picture momentum. Imagine a ball rolling down a hill. It starts off pretty slow and then as it gets further down the hill it picks up momentum and starts rolling faster.

Got it? If so, let’s discuss how to use the relative strength indicator to enter and exit trades.

Trading With the

Relative Strength Indicator

Do you recall from one of the previous lessons what the terms overbought and oversold mean?

Overbought: A technical condition that occurs when there has been a lot of buying and the price of the stock is considered too high and susceptible to a decline .

Oversold: A technical condition that occurs when there has been a lot of selling and the price of the stock is considered too low and a rally in prices is anticipated .

Okay, now let’s show you how to use this momentum oscillator:

With the relative strength index, oversold conditions are indicated by values in the 0 to 30 range and overbought conditions are indicated by values in the 70 to 100 range.

Sometimes you’ll see traders use 80 and 20 for overbought and oversold signals, I use 70 and 30.

Generally, this is how the relative strength index is used in trading:

1. Traders look to establish bullish positions (up direction) when the relative strength indicator dips below or touches the 30 line, and then rises back above it.
2. Traders look to establish bearish positions (down direction) when the relative strength indicator rises above or touches the 70 line and then falls back below it.

**For a quick recap on the terms bullish and bearish, please visit the option trading strategies page.**

Once the stock becomes overbought or oversold and you obtain an entry signal, you should always wait for some type of confirmation that a price reversal has occurred. There are several price confirmations that one can use however, we will review price confirmations in module 6.

I hope by now you are gaining an understanding of how momentum oscillators can be used to help you with finding trading opportunities.

Investing in stock options can be exciting and very rewarding. However, if you don’t properly learn how to use momentum oscillators, then investing in stock options will be a complete waste of your time and a drain on your wallet.

Module 5: Technical Indicators