Relative Strength Index (RSI) is a technical indicator that signifies oversold and overbought levels. It is relatively easy to as values below 30 signify oversold levels while values above mean overbought levels. It is tempting for the novice investor to jump on this indicator and start using it to predict price movement as it offers a simple strategy that is easy to follow. The danger is that used on its own RSI can lead to poor trading decisions.
Let’s inspect the price movement of Bank of America (BAC) from December 2011 to June 2012. You can see how the stock entered an upside trend and crossed the RSI 70 level on Jan 12th at around $6.50. From there you can see how the price kept moving up and the RSI moved even higher and stayed above 70 for extended periods of time on several occasions. By March 19th when the price peeked around the $10 (50% move from the date when RSI crossed the 70 level) RSI has moved above the 70 level 4 times and has stayed above for a total of around a month in the three month period Jan-Mar 2012.
It is better to use RSI as a confirmation of what you observe with other indicators and always keep in mind that markets tend to overshoot which may keep RSI in overbought or oversold territory for a significant amount of time.
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