Making Sense of Sun's Signals
Below is a chart of Sun Microsystems, back when it was a $60 stock. (It has since changed tickers and dropped 50 points.)
In this example, though, you'll notice that the RSI is highlighted in red in the overbought territory (above 70), and highlighted in green in the oversold territory (below 30).
Now remember, stocks can stay overbought for a long time. So, while a reading above 70 is considered overbought, it isn't necessarily a sell signal until the RSI moves back below 70.
There are different clues here that could have told you when it was time to sell the stock, and look for something with less risk.
First, you can see that from February to March, even though we saw Sun Micro trade higher, the RSI moved lower. This is what we call "negative divergence."
This negative divergence came after the RSI was slightly above 70 (overbought territory). Negative divergence showed that the momentum was slowing even though the stock was moving higher.
Higher moves in a stock's price that are not confirmed by the momentum (in this case, RSI) are likely to be followed by at least a slight decline in the stock.
Now, you might be staring at this chart and saying to yourself, "Hey, the RSI had already reversed from an even higher point in December, to below 70." This is true. But this is typical when a stock takes a breather and trades sideways.
Usually, when a stock is overbought, either it needs to correct by moving lower, or else it needs to trade flat, which also allows the average price to catch up to the current price. When you think about what the RSI actually is, this makes perfect sense.
Notice that this is what occurred in that same time period (December to February). That is why it's important to not only look at the indicator, but to compare this to what the stock is doing. A reading of 50 basically means the momentum is flat.
So again, when a stock stops trading higher, and only trades flat, it is normal for the RSI to move to the centerline.
Another confirmation that the RSI reading was not signaling a sell was that the support level (blue line), or 50-day exponential moving average (EMA), was not violated. Sure, at this point, you'd want to be extra-cautious, but this is not the same as negative divergence.
After reversing down from overbought territory, the negative divergence did occur, followed by a break in Sun Micro's support level in April, as well as the 50-day EMA. Noticing this and acting could have gotten you out at $45 before the drop to $35.
Now look on the right of the chart where the stock topped out at $65. The RSI dropped from above 70 to below 70 and almost immediately dropped below 50. If that wasn't enough for you, the RSI dropped through 50 a second time. And even though the stock seemed to try to bounce back up off of the 50-day EMA, the RSI dropped further down. This was another small (unmarked) negative divergence.
This told me to get out above $55 before yet another drop to $35 and, eventually, to the $2 range!
Below is a one-year chart of Motorola (MOT), before it became the $6 stock that it is today.
Again, here you can see that the RSI was in overbought territory, and then reversed back down below 70.
You can also see the negative divergence from August to September, and then again from mid-September to October.
If these signals weren't enough to spook you, the RSI confirmed its sell signal by crossing over the centerline (50), indicating that the bears were definitely in control. If you didn't listen to the RSI when the stock was trading up above $25, you should definitely have gotten out of the stock when the support level was broken, and the stock moved to $24.
You might have been upset that you missed selling at $25, but it would have been way less painful to lose a point then to wait for the stock to start skidding into the single digits.
