The Relative Strength Index RSI indicator is handy for analyzing the overbought and oversold phases. Can we use the RSI to understand if a small-cap is oversold or overbought and evaluate its purchase or sale?
The RSI is an indicator that I use a lot, perhaps one of the few technical analysis indicators that I think is really useful. Unfortunately for small caps analysis is not very reliable, and I will explain the reasons.
I will not explain what the RSI is for; as you already know, it is set at 14 periods, and when it goes below the value of 30, it indicates an oversold phase, while above 70 it indicates that the stock is overbought.
This type of indication is useful when predicting a stock rebound, then using mean reverting strategies. Stock indices or blue-chip stocks tend to bounce when they experience large price drops.
Related article: Small-cap stocks vs. blue-chip: two different approaches
The American S & P500 index is a classic example of an RSI indicator providing helpful information for entering and exiting the market.
On the other hand, small-cap stocks tend to continue in their direction for a long time, so it is challenging to predict a retracement with the RSI.
The oversold phases in small caps
When a small-cap starts a directional phase, it tends to continue both up and down. The low liquidity and capitalization of small caps mean that they are very volatile stocks.
In this article, I explain what affects the volatility of a stock: What increases market volatility?
The liquidity and capitalization of the share affect its volatility and the duration of any trend.
The RSI indicator is used to understand when a trend runs out and opens a trade in the opposite direction.
This type of strategy, called mean reverting, works terribly with small caps.
The Relative Strength Index of a small-cap could be in an oversold zone and remain there for a long time. The RSI could also go back, but without there being a real rebound of the stock.
The presence of few institutional investors means that small caps do not rebound because few support the price going down.
The combination of a few medium-sized hedge funds may be able to move the price of a small-cap and initiate an uptrend or a downtrend that would continue by inertia.
It is not a manipulation of the price; everything falls within the logic of supply and demand of the market. If there are only buyers or sellers, the price will continue in the unhindered direction. The smaller the small-cap, the more valid these logics are. The use of the RSI will therefore be completely useless.