Now that you know what's RSI, let's look at why use an RSI. You may want to use it for the following reasons:
Gauging overbought/oversold conditions: A primary reason to use RSI is to gauge a stock's current overbought or oversold condition. Being aware of an overbought condition can prevent you from chasing a too-high stock. An oversold condition on a stock may prevent you from panicking out of a stock by patiently waiting for a bounce to sell into.
Spotting price reversals: When a stock's RSI dips below 30 or rises above 70, it's a wake-up call to stay alert for potential reversals when they reverse back through those levels. These can be opportunities to enter or exit a position.
Spotting divergences: There are situations where the RSI may be a lead indicator in cases where a price divergence arises. This occurs when the RSI falls under the 70-band while the stock rises. The divergence between the RSI falling and stock price rising creates a divergence reversal setup as the stock usually joins the direction of the RSI. The same applies on the inverse. If the RSI bounces back up through the 30-band while the stock is still falling, it can be a divergence buy trigger to get into the position just before or as the stock starts to reverse back up.
Finding trade entries and exits: Utilizing the 30-band and 70-band crossovers can help you determine entries and exits. Longs can look to buy the 30-band bounce and sell the 70-band test or pierce. Short sellers can short-sell the fallback under the 70-band and buy cover at the 30-band or below. Divergences enable traders to get a heads-up on the potential stock price reversal as the RSI reverses first, and the stock follows. Get a startup guide to trading stocks online at MarketBeat.