Great news! Because you carefully researched a stock, you are enjoying its appreciation in value. This of course leads to the more difficult news of how do you know when to exit, and take the gains you have rightfully earned. The relative strength index (RSI) may be a great tool for you in this case.

The RSI is a momentum indicator which looks at the shift in price over a recent time period to determine if the security is overbought or oversold. The formula looks like this:

RSI = 100 – (100 / (1+ RS))

Where RS = (average number of days’ up close)/ (average number of days’ down close)

How many days should you use? Like anything else, it depends, but on average most investment tools use 14 days worth of data to compute this number.

Anything with a RSI value over 70 indicates the security may be overbought, and anything with a RSI value under 30 indicates the security may be oversold.

The reasons for a high or low RSI value can be diverse. For example, if a stock has a RSI of 75, the market may be efficiently responding to a condition where the stock was undervalued, and stock prices are ticking up daily in response. Just as likely, however, there can be a lot of positive buzz surrounding a particular stock, and the behavioral part of finance can be at play, rewarding a stock for being successful with more success. If you suspect your stock was already fairly valued, and suddenly you are seeing a substantial increase in portfolio performance, you may want to look at the RSI, and create an exit strategy. Possibly a re-entry strategy as well, once the stock price is back on sale.

If you are not the type to perform fundamental analysis on a particular company, you can try day trading options using this RSI indicator. In a future post, I will do a case study of the RSI Indicator on a heavily punished (oversold) ETF, buy an option on it, and let you know where I stand.