Understanding the process of how to calculate RSI serves as a valuable tool in technical analysis—but taking a broader view will help you profit more in the long run

Technical analysis is the process of analyzing a stock’s past and historical price movements to attempt to determine future prices.

One form of technical analysis is the Relative Strength Indicator (RSI). It charts a stock’s current and historical strength, or weakness, based on closing prices over a recent trading period. Specifically, it looks at whether a stock’s price on each of those trading days in the period closed up or down compared to the previous day’s closing price. The RSI then compares the overall magnitude of a stock’s recent gains to the magnitude of its recent losses and turns that data into a number that ranges from 0 to 100.

Here’s more on how to calculate RSI:

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Learn how to calculate RSI to add another layer of technical analysis to your stock selection process

J. Welles Wilder developed the indicator and introduced it in his 1978 book New Concepts in Technical Trading Systems.

The RSI is most typically used on a 14-day time-frame, as first introduced by Wilder. Since then, the 9-day and 25-day Relative Strength Index indicators have also gained popularity.

The center line for RSI is 50. Readings above and below are meant to suggest a bullish or bearish outlook, respectively. On the whole, a reading above 50 indicates that average gains are higher than average losses and a reading below 50 indicates that losses are winning out. RSI enthusiasts look for a move above 50 to confirm bullish signals or a move below 50 to confirm bearish signals.

Wilder recommended using 70 as an overbought level (buyers are too optimistic and the stock could fall) and 30 as oversold (sellers are too pessimistic and the stock is ready to bounce upward).

Use technical analysis, including the process of how to calculate RSI, as only a part of your stock selection process to make the best investment choices

As I’ve often mentioned, I got my first investment-related job at age 16. Part of my work was drawing up charts, both line charts and point-and-figures. In my mid-20s, I worked for a couple of years as the technical analyst at a Toronto brokerage firm, though I did fundamental research there as well.

Technical analysis can be a useful tool, if you recognize it as one of many tools. Before making any recommendations or transactions in client accounts, I always look at a chart. However, I don’t look at the chart for a prediction on what’s going to happen. I look to see if the pattern on the chart seems to support the view that I’ve formed of the stock, based on its finances and other fundamental factors.

I find it encouraging if the two seem congruent, and they often do. But sometimes one contradicts the other. That’s when I know I have to dig deeper.

One thing I’ve observed over the years is that charts and technical analysis always seem to provide a misleading answer just when it can do the most damage to those who rely on them. That’s why I think it’s a big mistake to base investment decisions exclusively on charts or technical analysis of any kind.

Take a broad view in your stock analysis to make stronger picks

You need to look at the overall picture, rather than confine your view to your favourite selection of easily accessible statistical information. That’s the trouble with zeroing in on any single facet of investing. With a narrow view, you can get lucky and make a handful of brilliant trades. But to profit consistently in a long investing career, much less make any serious money, you have to take a broad view of the market and economy, you have to learn how to single out stocks that will go up and stay up, and you have to learn to diversify.

Many investors are well past age 35 when they make that essential discovery. The key to profiting from technical analysis for stocks is to avoid looking to the pattern on the chart for a prediction of what’s going to happen. Instead, see if the chart seems to support your view of the stock, based on its finances and other fundamentals.

Technical analysis including how to calculate RSI, has it uses—but use our three-part Successful Investor approach to benefit the most

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

What is your opinion of using technical analysis as the sole factor in whether or not to invest in a particular stock?