One of the common momentum indicators, the Relative Strength Index or RSI is a refined way of seeing the price momentum. Momentum is the rate of change of the price, and this can be confusing, as sometimes the price can still be increasing while the momentum has started to decrease (this is referred to as ‘divergence’). This is because momentum indicators usually work by adding stock price differences, or simply the number of ‘up’ and ‘down’ days over successive fixed time-periods, usually around 10 days to a fortnight. Now, there can be a problem to methods like this. Any big stock share price rise or fall happening on any one particular day will result in a clear signal. However, if share prices then show only small marginal increases in the following days, in a ‘normal’ momentum indicator the signals these methods provide will be distorted when the exceptionally large change in price drops out of the calculation. This is a serious flaw when relying on such an indicator to time short-term buying and selling.
A trader by the name of Welles Wilder tackled this problem, and in 1978 invented the Relative Strength Indicator to assist in his trading. The Relative Strength Indicator is firstly nothing to do with relative strength as it is usually referred to in trading – the relative strength of different sectors, or of one stock to another. The relative strength in its name is to do with comparing the strength of the average up move in the stock to the strength of the average down move. The RSI indicators aims to address drawbacks in other indicators that attempt to measure share price momentum in order to spot possible future turning points.
The Well-Wilder Relative Strength calculation solves this by averaging as opposed to simply adding the changes on ‘up’ day and ‘down’ days. The period is often taken as fourteen days. The average up move over the last fourteen days is compared to the average down move, and then converted to a standard scale, such as a percentage. The RSI will typically display a line that has an upper limit of 100 and a lower limit of zero and which fluctuates quite significantly between these two figures. Because they are averages, the RSI indicator will seldom reach the extremes, so any value above about 70% or below 30% is considered significant and these are considered the the key levels for buying and selling decisions.
The strategies surrounding the RSI are similar to those applied with many other technical oscillators. When the value is over 70%, the stock is considered overbought. Being overbought mean that there has been a rash of enthusiasm for buying the security, perhaps to the point of excess. The price reached may be high enough that some traders may be considering selling and taking a quick profit, which can cause a reversal, and one way to use the RSI is to automatically sell when the value gets that high.
On the other hand, if the RSI gets down below 30% the stock may be oversold, which means that everyone who was interested in selling and getting out of their ownership position has done so. The corollary of this is that the stock is now relatively cheap, and this may indicate that it’s worth buying. As with all technical indicators, it’s best to look for corroboration before basing a trade on these values, but they are at least an indication to look out for a tradable position.
The other way to use a technical indicator is to look for periods when the oscillator is moving in the opposite direction to the price, and as stated above this is known as a divergence. It signals that the move is not continuing indefinitely. The price may still be going up, and appear to be in a good trend, but if the RSI starts falling it means that the trend may be ending soon, and it would not be a good time to go long.
If you are used to using the momentum indicator for your signals, you may be pleasantly surprised by the performance of the Relative Strength Indicator. You will find that the RSI is much faster when signalling a change in the trend.