Relative Strength Index Relative Strength Index: Technical Tuesday: Strength, Relatively Speaking Mark Bail explains the market indicator known as the Relative Strength Index. Ladies and Gentlemen...Mark Bail. Thank you, Carl, and hello again Sleuths. In the Sept. 13 edition of Technical Tuesday, I analyzed two small-cap market averages -- the Russell 2000 Growth Index (RUO) and the Russell 2000 Value Index (RUJ), the failure of which to successfully challenge their early August highs does not bode well in the short-term for bulls foraging in the small-cap patch. In fact, both indexes are getting dangerously close to their late June lows -- potentially very bearish occurrences. But let’s put a pin in that for now. One of the indicators I used to interpret the technical condition of those two indexes in that Sept. edition was the Relative Strength Index. This market indicator is one of the three primary components of the trading system I use in my MST Trader Alert, and it’s certainly worthy of its own Technical Tuesday. The name Relative Strength Index was actually an unfortunate choice for this market tool. The term "relative strength" is bandied about frequently and generally refers to the relative price performance of a stock or market to that of another stock or index. However, the Relative Strength Index -- or RSI, as we market technicians refer to it -- is something quite different. Because of the similarity of its name with the term "relative strength," the value actually depicted by the RSI is often misunderstood by those lacking a real understanding of this indicator. Relative Strength Index: J. Welles Wilder, Jr. The RSI is a momentum indicator that measures the internal strength of a stock or index against itself. It was developed by J. Welles Wilder, Jr., who introduced the concept in his 1978 book "New Concepts in Technical Trading Systems." The primary use of the RSI has been to evaluate the strength of the momentum of a stock or market average. It compares the closing prices on days that a stock or market average finishes higher with the closing prices on days when the stock or market average finishes lower -- over a specific period of time. In his book, Wilder used a 14-day period, which is also the time frame I use in the MST Trader Alert. You can certainly use other time frames. In fact, Wilder suggested a seven-day period to trade short cycles. A nine-day period is also commonly employed to trade or examine a stock or index on a short-term basis. And 15, 21, 25, 30 and even 45-day periods are frequently used for an intermediate cycle. Feel free to experiment. Once you’ve settled on your time period, you simply plug it into your calculation. Here’s the formula: RSI = 100 - [100/(1 + RS)] Average Gain = (Total Gains/n) / (Total Losses/n) First RS = Average Gain / Average Loss Smoothed RS = [(previous Average Gain) x (n-1) + Current Gain]/n / [(previous Average Loss) x (n-1) + Current Loss]/n n = number of RSI periods As you can see, the average gain is equal to the sum of all the gains divided by the number of periods you’ve chosen. Similarly, the sum of all losses divided by your chosen time period gives you your average loss. Then, divide the average gain by the average loss. Finally, the resulting value is smoothed using the previous period’s average gain and average loss (the smoothed RS calculation). Relative Strength Index: A Better Understanding Math not your relative strength? Not to worry. You don’t need to know how to calculate RSI. But knowing how it’s constructed does engender a better understanding of what the indicator value represents and how to use it properly. In Part 1 of our discussion of moving averages, I said that trading software packages will actually calculate the indicator for you. Those same software packages will take care of the number-crunching for the RSI as well. But if anyone ever asks you at a cocktail party how to construct the RSI, you are now equipped to rattle off the formula in the blink of an eye. You’ll be the life the party (lampshade not included). OK, now that we’ve mastered all of the intricacies of the RSI formula, let’s see what you’re left with as a result of this high-level math. The value of the RSI ranges from 0 to 100. Traditionally -- when the RSI is above 70 -- a stock or index is considered to be overbought. And when the RSI has a value below 30 -- a stock or index is thought to be oversold. Those values go to 80 and 20 in bull and bear markets, respectively. Thus, the RSI helps you pinpoint momentum extremes and helps you locate turning points. Now, let’s examine a few ways that the RSI can assist you in making trading and investment decisions. Operative word: "assist". You should never rely on any one indicator or tool when forming conclusions that will affect the value of your trading or investment account. Always use more than one indicator. No one trading tool works all the time. That’s not to say you always need to employ a battery of indicators -- for some people, a few will suffice. In fact, using too many indicators can have a negative effect on your efforts -- you run the risk of constantly second-guessing yourself -- a common malady of many traders known as "paralysis by analysis." But you will be well served by employing at least a few different tools that fit your trading or investing temperament, time frame and goals. And use these tools to confirm the signals you receive from one another. Trading and investing is a game of odds. And putting those odds in our favor increases the likelihood of achieving success. My second reason for using the word "assist" is that the RSI is normally not used as a primary trading indicator but, rather, to confirm another signal, which is how I use it -- to evaluate the strength of a momentum signal I’ve received from another indicator. There are three different ways to use the RSI. The first two methods deal with signals generated from moves into the overbought and oversold levels I cited above. The third is the one I use in the MST Trader. Any one of these methods -- employed properly with other valid trading setups -- can improve your results. The first method attempts to capture a change in momentum after a stock or index has become overbought or oversold. To illustrate how this concept is used in an actual trade, let’s look at an example of buying a stock. The principle is exactly the reverse when shorting a stock or index. Assume that you’re interested in purchasing shares of Tulip Fever (BULB). Again, a stock is considered oversold when the RSI falls below 30. If the RSI then rises back above 30, that’s considered bullish. This positive change in the RSI value -- following right on the heels of an extreme oversold reading -- is interpreted to be a sign of strength. Accordingly, this bullish reversal from an oversold level -- all other things being equal -- could provide you with an attractive entry point for your purchase of BULB shares. As I said, the principle is exactly the reverse on the short side. So if you were looking to short shares of BULB, you could wait for the RSI to rise above 70 and then fall beneath that level. When the RSI drops below 70, the RSI is "flashing" a bearish signal. Again -- all things being equal -- the RSI has offered you an attractive entry for your short from an extreme overbought level. The second method is a variation of the first one. This time you wait for a divergence to occur between the extremes in the RSI value and the underlying stock or index. Then you wait for the RSI to cross back above 30, if buying -- or slip below 70, if shorting. For example...Let’s assume that the price of BULB has been falling -- as has its RSI value -- and that BULB makes a lower low than the previous low. But the RSI -- while oversold below 30 -- makes a higher low. That’s what’s known among market technicians as a divergence. Now, keep in mind that a higher low in the RSI means that -- based upon its recent closing prices -- the stock is exhibiting a greater degree of relative strength compared to the stock’s earlier (higher) low. Thus, the RSI is telling you that BULB is not as weak that the stock’s price action appears to suggest. If this scenario plays out as I just described, here’s what you do. Wait for the RSI to rise back above 30. Now, consider what has just happened. You have a stock that has both formed a bullish divergence and reversed from an oversold extreme reading. Again -- all things being equal -- the RSI has just helped you spot an attractive entry point to make your purchase. The concept works the same for a short. When the stock or index makes a higher high but the RSI fails to reach the same peak, you have a bearish divergence. Your entry signal would be the RSI subsequently dropping below the 70 (overbought) level. Relative Strength Index: Using the Centerline The third method uses the 50 level -- or centerline -- as your trading signal. Readings above 50 are considered to be bullish. And readings below 50 are thought to be bearish. It sounds simplistic, but it’s not, because the RSI is best used as a complementary tool. And that’s exactly how I use the RSI in the MST Alert -- to confirm my initial trade entry signal. Rather than acting on that initial signal -- from another momentum indicator -- I wait for the RSI of the underlying stock I’m examining to confirm the strength of that momentum -- by crossing above or below the 50 level. This way, I’m only acting upon confirmed trading signals, thereby increasing my odds of success. But I don’t act even after this confirming signal from the RSI. I use a third confirming indicator that...Ah, but it seems we’re out of time. Summing up...The RSI is a great role player. It helps filter out the mediocre trading signals and highlight the better opportunities. And the confirmation of strength that the RSI offers helps me trade with a greater degree of confidence. That alone makes its use worthwhile. So if you’re not yet using the RSI to assist you in your buy or short entry decisions, give it a try. None of the methods I’ve described is terribly complicated, and any one or all might help you buy or short a stock -- or purchase an option -- at a more optimal point. But even if it just keeps you out of some losing trades or lackluster investments -- the Relative Strength Index will have served you well. After all, avoiding losing money is a corollary to making it. Trade well... Mark Bail ps... To learn more about the MST Trader -- and why wouln't you want to? -- you need only click here: |
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