Understanding Stocks

136 UNDERSTANDING STOCKS
CAT Daily
Realative Strength Index (14)
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Figure 12-3 Relative strength indicator
12/06/02
For example, if the stock price is dropping, but the RSI rises above
70 and then crosses back down, this is a sign that the stock might
reverse direction (this price reversal is called divergence). Conversely,
if the stock price is rising, but the RSI drops below 30 and crosses back
up, the stock might reverse. The idea is that the stock price will eventually
move in the direction of the RSI.
In Figure 12-3, the RSI dropped as low as 20 twice in the last year,
signaling that Caterpillar might be oversold. For example, in August
the RSI fell to 20 and crossed back up, and the stock immediately
reversed direction. Then, in October, the RSI again fell to 20 and
crossed back up. Note what happened to Caterpillar—the stock
reversed its downtrend and began a strong rally that continued for a
month.
If you are critical of technical analysis, you can argue that the RSI
generated a series of short-term signals, some of which were unclear.
This is why it’s so important to use the RSI in conjunction with other
technical indicators. On the other hand, the RSI did work flawlessly in
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