NEW DELHI: The domestic equity market picked up momentum in May and looks like a fresh leg of the bull market has started. The key to making money in an equity market is to pick the right kind of stocks .
Measuring the strength of a market trend is a primary concern before an investor makes an entry into any stock(s). They should always do their own analysis with a combination of indicators to determine their investment strategy, analysts said.
The RSI is one such indicator that analysts use to determine whether the asset is in an oversold or overbought territory. If it shows a value less than 30, it indicates that the stock, or the index, is in the oversold territory, while a value higher than 70 suggests an overbought status.
The strength or weakness of a security is based on closing price over a specified trading period, creating a reliable metric of price and momentum changes.
“Relative strength index or RSI is a well-versed momentum-based oscillator, which is used to measure the speed (velocity) as well as change (magnitude) of directional price movements that give a clear measure of the strength of a trend. One can also get the idea of whether the present trend is likely to reverse or continue,” said Rohit Gadia, Founder & CEO, CapitalVia Global Research.
Almost 50 stocks in the BSE500 index are trading at an RSI of 30 or below it, which indicates that these stocks are in the oversold territory. The chance of a bounceback is much higher in these stocks, which include the likes of Emami, HT Media , AIA Engineering , Greenply Industries , Force Motors , Firstsource Solutions , Dewan Housing Finance , CEAT and Cipla .
Almost 20 stocks are approaching an RSI level of 70 or more, indicating that they are in the overbought zone and chances of a correction or some consolidation is much higher on these counters.
Stocks that are trading around an RSI of 70 include PI Industries , Timken India , DB Realty, Blue Star, Dhanuka Agritech , Asian Paints , Cairn India , Bosch, Century Textiles , Dalmia Bharat, Geometric , Aditya Birla Nuvo and HDIL .
Stocks for which the RSI is approaching 30 or has hit 70 are a clear buy on dips or sell on rallies.
But, often the problem with the RSI is that it is a lagging indicator. This means it always provides a signal after the price has already moved in the desired direction.
“To use RSI, an investor should first look the price pattern and analyse the price itself with the help of any trendline – support and resistance – before taking a decision,” said Gadia.
The RSI is more popularly used to identify divergence between the movement of a scrip and an index and also to identify overbought or oversold levels. This is a mechanical interpretation, based on their strength scrips define their own overbought and oversold status, experts said.
Traders should be careful before making a decision based on RSI. Most of the time, a scrip will keep on rallying supported by a strong momentum based on news or other fundamental reasons.
The opposite is true when the market momentum is weak. You will find many stocks in the oversold zone because there has been a broadbased selloff.
“Some scrips, especially emerging stars that are in the high-growth space, will have non-stop rallies and refuse to correct despite having RSI readings of even 90. In a bear market, a scrip may get stuck in an oversold zone for a long time,” explained Mazhar Mohammad, Chief Strategist – Technical Research & Trading Advisory, Chartviewindia.in.
Traders should differentiate the right oversold/overbought levels as defined by the behaviour of individual scrip. Traders can also search for chart patterns on the RSI chart.
” bearish pattern on the price chart accompanied by a negative divergence in the overbought area of RSI chart may act as some sort of self-confirmation of an impending fall,” Mohammad said.
If the RSI is approaching the 70 mark and the stock price is following the same trend, there is always a possibility of a trend reversal from that level and we could see some correction in the stock. Usually, the RSI should be studied along with other moving averages and other momentum indicators.
In technical analysis, decisions are made based on the weight of technical evidence. This means no single indicator in technical analysis can be used in isolation. It has to be used only along with other indicators, Mohammad said.
“If there is a sell signal on the RSI chart, one needs to look for confirmation from other technical indicators also for better success rate in trading. Only when other indicators suggest such bearishness, should a trade be initiated in that direction,” he explained.