A very interesting indicator in stock markets is something called the Relative Strength Index. This is a tried and tested indicator that has been around since the late 1970s, and focuses on momentum: while indicators like the SMA look at average prices of stocks, the RSI looks at the speed with which stock prices are changing. The Relative Strength Indicator is calculated from the average gains the stock has made over a short period of time, compared to the average losses.
The resulting RSI for a stock varies from 0 to 100. An RSI number over 70 means that the stock is ‘overbought’ - i.e. its demand and gains are too high, and the price is not justified. An RSI number below 30 means that the stock has fallen too sharply and is ‘oversold’, i.e. its current price is likely below its real value. There are buying opportunities in oversold stocks.
Arvind Ltd for example, riding high on Q2 results, figures in the RSI overbought screener with an RSI score of 79+, suggesting that the stock is overbought at a price that is difficult to defend, and the stock has been gaining sharply over the past few days.
Axis Bank on the other hand, has been pummelled badly in the stock market after its Q2 results yesterday showed much higher bad loans than expected, and the RSI score of 28.7 suggests that the stock is now oversold, and the price is below its real value.
Another popular indicator related to the RSI is the Money Flow Index. The MFI is essentially the RSI plus volume. This looks at price changes as well as the volume of money going into the stock, and the money going out, to calculate the MFI. An MFI level above 80 means again, that the stock is overbought and may not justify its current high price, while an MFI below 20 means that it’s oversold.
Great Eastern Shipping for instance has turned up in the MFI overbought screener list with a score of 93, and the stock has already started seeing pullback. The company had been trading over its 200 day SMA. On the other hand, Asian Paints with an MFI of 14.34, has landed in the oversold list, struggling on the back of Q2 results that showed rising input costs.
An overly exuberant or pessimistic reaction from investors to a company’s financial results or management remarks can often propel a stock up and down. The RSI and MFI are momentum indicators that can help show excessive optimism or pessimism for a particular stock. It helps investors identify companies that are being overvalued or undervalued by the crowd, and respond accordingly.
Note: RSI and MFI have to be used in conjunction with other parameters like MACD to get exact entry and exit points. For eg. Axis bank which figures in Low RSI implying oversold has an MACD and MACD signal of -15.07 and -13.67 respectively - implying that the worst is not over for the stock. Will discuss this interaction in an upcoming post.
Links: RSI and MFI screeners
