Technical Analysis | Relative Strength Index

Technical Analysis > Relative Strength Index

When talking about the strength of a stock there are a few different interpretations, one of which is the Relative Strength Index (RSI) . The RSI is a comparison between the days that a stock finishes up against the days it finishes down. This indicator is a big tool in momentum trading.

The RSI is a reasonably simple model that anyone can use. It is calculated with the following formula.

RSI = 100 - [100/(1 + RS)]

where:
RS = (Average of n-day up closes)/(Average of n-day down closes)
n= days (most analysts use 9 - 15 day RSI)

The RSI ranges from 0 to 100. A stock is considered overbought around the 70 level and you should consider selling. This number is not written in stone, in a bull market some believe that 80 is a better level to indicate an overbought stock since stocks often trade at higher valuations during bull markets. Likewise, if the RSI approaches 30 a stock is considered oversold and you should consider buying. Again, make the adjustment to 20 in a bear market .

The shorter number of days used, the more volatile the RSI is and the more often it will hit extremes. A longer term RSI is more rolling, fluctuating a lot less. Different sectors and industries have varying threshold levels when it comes to the RSI. Stocks in some industries will go as high as 75-80 before dropping back and others have a tough time breaking past 70. A good rule is to watch the RSI over the long term (1 year or more) to determine what level the historical RSI has traded at and how the stock reacted when it reached those levels.

Above, we have an 14 Day RSI chart for Pakistan Oilfields (POL). The RSI is the purple line, its scale is the numbers on the right hand side that go from 0 to 100 above the candlestick graph. Notice the RSI was above the 60-70 level in late December and early January and then the stock sold off. Also, notice around the last week of January when the RSI dropped to 25 the stock climbed up nearly 30% in just a couple weeks.

Using the moving averages , trendlines, divergence , support , and resistance lines along with the RSI chart can be very useful. Rising bottoms on the RSI chart can produce the same positive trend results as it would on the stock chart. Should the general trend of the stock price tangent from the RSI, it might spark a warning, the stock is either over/under bought.

The RSI is a great little indicator that can help you make some serious money. Beware big surges and drops in stocks will dramatically affect the RSI, resulting in false buy or sell signals. Most investors agree that the RSI is most effective in "backing up" or increasing confidence before making an investment decision , don't invest simply based on the RSI numbers.