Relative Strength Index (RSI)

This article was written some years ago, but is very relevant to today. The charts used to illustrate the text are now somewhat dated, but still relevant for the present purpose of teaching a technique.

In 1978 a rather remarkable book was published in America called New Concepts in Technical Trading Systems. In it, J Welles Wilder Jr. introduced some new ideas and indicators that were to permanently change the face of technical analysis.

One of the most popular of his new indicators was called the Relative Strength Index, or as it is usually referred to, the RSI. In hindsight this was an unfortunate name because it is forever being confused with the older indicator, simply called Relative Strength, and which is based on a totally different concept.

Relative Strength was discussed in two earlier Charting and Technical Analysis articles with that name. Relative Strength simply measures how strong a share is, relative to the overall market, and is a simple ratio.

RSI is an indicator that measures momentum and relies on a somewhat more sophisticated concept and calculation. Momentum is the rate of change in price. If prices are changing rapidly in one direction, we say that its momentum is high. If prices then begin to change less rapidly in that direction, then we say that it is losing momentum.

In this age of computers, there are very few people who calculate RSI by hand. It can be set up on a spreadsheet, as J Welles Wilder Jr. did in the 1970’s, although it is somewhat more complicated than the formula suggests. Readers wishing to do this should consult the explanation in the original book or the example in Trading for a Living by Dr Alexander Elder, which is much easier to obtain. The formula provided here is only used to obtain the first value of RSI and is shown in order to explain the concept of the indicator:

RSI = 100 – (100 / [1 + RS])

The numbers in the formula are only there to cause the indicator to fluctuate between 0 and 100. The important bit is RS:

Average of n days HIGHER closes

RS = ------

Average of n days LOWER closes n = the number of periods over which the momentum is being calculated. J Welles Wilder Jr used 14 days, but later analysts seem to like periods as short as 5 days, with 7 and 9 days being quite common.

If we were using 14 days as the period, what RS means is that we take the last 14 days and identify which of them had a closing price (the last sale of the day) that was higher than the day before. We

total these higher closing prices and divide by 14 to give us an average higher close over the 14 days. Then we do the same for the lower closes, to get an average lower close over the 14 days. We then divide the average of the higher closes by the average of the lower closes.

Two examples of RS make it easier to understand:

1. If prices are rising:

• If the average higher close is $5 and the average lower close is $2, then RS is higher at (5 / 2) = 2.5 than • If the average higher close is $2 and the average lower close is $2, when RS is (2 / 2) = 1.0.

2. If prices are falling:

• If the average higher close is $2 and the average lower close is $5, then RS is lower at (2 / 5) = 0.4 than • If the average higher close is $2 and the average lower close is $2, when RS is (2 / 2) = 1.0.

ABS - A.B.C. LEARNING CENTRES LTD 210301-280803 400

300

200

100

0 9 unit 100

RSI

0 M A M J J A S O N D J F M A M J J A S O N D J F M A M J J A S 01 02 03

The chart shows a 9-week RSI for ABC Learning Centres (ABS), which would be suitable for active investors. A 9-day RSI would be more suitable for short term traders.

In the main chart at the top, we have a weekly bar chart of the price. In the sub-chart at the bottom, we have the RSI line. The RSI fluctuates or oscillates between 0 and 100. It is usual to have two reference lines, shown on the chart as black dotted lines at 30 and 70. These are generally known as the overbought line (70) and the oversold line (30). These are jargon terms:

• Overbought: buyers have bid prices up too strongly.

• Oversold: sellers have offered prices down too aggressively.

The implication leads to the simplest rule for using the RSI, which is to buy when the RSI falls below 30 and rises back up above it and to sell when the RSI rises above 70 and then falls back below it. This is a rule that serves short term traders rather better than investors, because it involves numerous transactions for small gains. It can be used by short term traders in both trends and trading ranges. A trading range is when the price moves generally sideways.

It also looks easy on a quick examination, but is not so easy in practice. It is best used in conjunction with analysis of the individual bars. It is unwise to act on an RSI signal alone, unless there is a price signal to confirm it.

The RSI behaves quite differently in a trend, compared to the way it behaves when the price trades generally sideways. This is important for investors to understand, because RSI should be used differently in different situations.

From listing in March 2001 through to around the end of that year, ABS was in a strong uptrend. In this period, the RSI behaved in typical fashion, oscillating in and out of the overbought zone above the 70 line, but never falling into the oversold zone below the 30 line to give a buy signal.

In a downtrend, the behaviour of the RSI will be the opposite. In the first half of 2002, the chart shows ABS falling. During this period, it oscillated in and out of the oversold zone below the 30 line, but did not rise above the 70 line to give a sell signal. This behaviour was repeated in the downtrending phase after the peak in September/October 2002.

The way analysts try to deal with this is by changing the trading rule depending upon the market conditions. They do this by using different values for the overbought and oversold levels, depending on the trend. So, if there is an uptrend, the oversold zone is raised to the 40 line, shown in green on the chart. If the trend is down, then the overbought line is lowered to 60, as shown in red on the chart. This is not a perfect solution, but works quite well most of the time.

While short term traders will use RSI in sideways markets and to sell short in trends, investors should use it mainly to time their buying decision. A cursory examination of the chart in 2001 will show that, in an uptrend, the RSI will give many sell signals that are way too soon. These are for the trader and should be ignored by investors. Instead, investors’ main use of the RSI is to help find the best times to enter the trend, by buying when the RSI falls into the oversold zone and rises out of it again, confirming a price signal.

The RSI can be used to help with selling decisions for investors. I discuss that below:

When we first start to become interested in investing or trading, we naturally tend to focus on what stock to buy. A little later, we may begin to focus on the right time to buy.

This concentration on the buying decision is well illustrated in the seminar market. If a seminar is advertised to explain what stocks to buy and when, it will usually draw a large audience. However, if a seminar is advertised to explain when to sell, it will only draw a fraction of the audience attracted to the first seminar. Most investment and trading books also concentrate on the buying decision.

Most brokers make many more buying than selling recommendations, although that is partly due to other factors.

On the other hand, most experienced investors and traders will have come to the realisation that the selling decision is far more important and difficult than making the decision to buy. Experience will show that many investors or traders, all of whom bought at the same time, will have widely different results. Their results will vary from small profits to large profits and from small losses to large losses. The only difference is that some sold too soon, some sold at around the best time, some held on too long and others rode the stock into large losses.

The art of investment in a nutshell is to buy a range of good companies that are trending up. Then, sell those that fall out of their uptrend and buy more of the ones that keep rising. When they eventually fall out of their uptrend, sell them. This is easy to say, but difficult to do. However, the most important part is deciding when to sell.

It is always sad to see someone buy a good stock, which increases dramatically in price, yet they let that profit get away from them by selling too soon, or holding on too long.

The Relative Strength Index, or RSI, was introduced above. The focus was on using the RSI for the buying and selling decisions for traders and for the buying decision for investors. The selling decision for investors is discussed below.

The problem is that RSI was designed for short term trading. This means it was useful for picking the time to jump in and out at the start and finish respectively of each upswing in a trading range, or a medium term trend. Then it was noticed that RSI was also very useful for investors in getting into a medium term trend, by helping to identify the start of a new upswing within the trend. However, it is important to appreciate that while an investor can use RSI in the same way as a trader to buy, to sell at the same time would not be good. RSI has a role in the investor’s selling decision, but it requires a different approach.

RSI is a bit like an X-Ray. It can tell us what is happening with the momentum of price change beneath the surface of a trend. The oscillations of the RSI line tell us this by themselves, as explained above. However, there is an additional way to look at the RSI oscillations.

Technical analysts have observed that it can be useful to observe whether each higher peak in the price trend is confirmed by a higher peak in the RSI line. In a strong trend this will be what happens. However, if a trend is slowing down, it is often evident in a lower peak on the RSI line, even though the price is continuing to make a higher peak. This is called a ‘divergence’ in technical analysis jargon and simply means that the peaks in price and RSI are diverging.

The really interesting thing about divergences is that there is nearly always a divergence – the RSI failing to make a higher peak, when price makes a new high – before important tops in uptrends. Aha, you say, if there is a divergence, it is time to sell. Unfortunately, it is not that simple.

The problem is that there is nearly always a divergence before the end of a trend, but there are many more divergences that do not lead to the end of the trend. In long uptrends there will often be several divergences well before the end of the trend. This is illustrated in the weekly chart of Toll Holdings (TOL):

TOL - TOLL HOLDINGS LTD 030197-100903 1000 MOV AVS 30(0) E D

Buy 2 B Sell 2

Buy 1 A

100 Trend Sell

Sell 1

30 14 unit 100

RSI

0 JFMAMJ JASONDJFMAMJ JASONDJFMAMJJ ASONDJFMAMJJASONDJFMAMJ JASONDJFMAMJ JASONDJFMAMJ JASOND 97 98 99 00 01 02 03

You will see that at B, C and D there were divergences between the 14-day RSI peaks and price peaks in the 2000 through 2002 uptrend. They are marked with dotted red lines marking the price and RSI peaks. To have sold when these divergences appeared would have been unfortunately premature. It was only the divergence marked F and with dotted green lines, which was at the right time.

The way we deal with this is to recognise that divergences are useful early warning signals of a loss of momentum. They therefore serve the purpose of alerting investors to be watchful for a possible failure of the trend. One thing we might do is to move the level at which we will sell some of our position to protect our profits closer to the recent price action.

The key, though, is that we do not act on a divergence unless we see a signal that the trend may be finished. This might be from a trend following indicator, like a moving average, or a price signal like a lower peak followed by a lower trough on the price chart. The chart of Toll will be used to illustrate the method, using the popular 30-week moving average, shown on the price chart as a brown line.

Suppose that we bought Toll at the point marked Buy 1 on the chart, when it broke above the horizontal red resistance line in late 1998. At A, a divergence appeared. We might then have sold at the point marked Sell 1, when Toll crossed below the moving average, or when it broke below the trading range of several months duration, which was effectively the same time.

Toll did not decline very much and at the point marked Buy 2, we might have bought back in as it moved to a new high above the horizontal red dotted resistance line in early 2000.

Divergences between RSI peaks and price peaks occurred at B, C, and D. However, the price stayed above the moving average and the trend remained intact by always staying above the last significant trough in price. To have blindly sold on the divergences would have led to missed profits.

Then at F, another divergence appeared. This time, Toll’s price broke below the moving average, the signal to sell at the point marked Sell 2. If a price signal had been used instead, we might have sold at the point marked Trend Sell, when Toll had made a lower peak and fallen below the last trough, marked with a dotted red line. This was somewhat later, but still captured most of the uptrend.

In conclusion, RSI divergences can be useful early warning signals for investors, but should not be acted on without a confirmation from a trend-following indicator or a signal from the price chart. It might be argued that we could rely on the trend following technique alone. However, that would often mean continuing blissfully unaware of the possible danger and perhaps being taken by surprise and not being prepared to act quickly on a trend change signal.