Evaluating Stocks Using Relative Strength Index


((C) Sam Burt 2010)

The Relative Strength Index (RSI) is a useful tool for analyzing pricing and purchasing trends and determining momentum characteristics of a particular stock. The calculation is simple, but the interpretation can be relatively complex.

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RSI does not draw any conclusions or comparisons against the overall market; it is purely used for evaluating trends in an individual stock and predicting upcoming shifts in the price. It is calculated by the equation RSI = 100 – 100/(1+RS), where RS is the average stock price over all the days it closes up divided by the average price over all the days it closes down. In short, RS is the average gain divided by the average loss.

The RS value is set for a given period of time (typically fourteen trading days); therefore, RSI values are dependent on the amount of time chosen. Adjusting the time period will change the sensitivity – shorter times increase sensitivity and longer times decrease sensitivity. You may need to adjust the sensitivity as appropriate for the volatility of the stock being analyzed.

By definition, RSI is a scale that operates between zero and 100 – it registers zero when there are no gains over the RS period, and registers 100 when there are no losses. Through incorporating prior and current results, RSI has a natural smoothing effect on the data.

Now that you know how to calculate it, what do you do with it? Here are several possibilities:

Oversold/Undersold – The original use was to establish threshold values for oversold and overbought stocks. Generally, an RSI above 70 indicates an overbought stock and an RSI below 30 indicates an oversold stock. Outside of the 30-70 range, trends for either gains or losses are unusually strong and thus caution is advised.

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Crossovers – Some investors use an RSI of 50 as a simple crossover point at which to buy and sell. When RSI crosses above 50, buy; when it crosses below 50, sell. Variations involve creating “fast” and “slow” moving averages of RSI over different time periods, and using the crossover between those two averages to determine the buy and sell points.

Divergences – Divergences occur when the momentum in the RSI does not follow the momentum in the price. This suggests a coming reversal in the price momentum – in a “bullish” divergence, the stock makes a lower relative low point and the RSI makes a higher low point (suggesting a temporary price dip and increasing price momentum). “Bearish” divergence means the stock makes a higher relative high point and the RSI makes a lower one, suggesting a temporary price rise and overall decreasing price momentum.

Failure Swings – Failure swings are used to identify impending market reversals. Let’s start by considering a peak value of RSI around 70. Imagine a subsequent drop to 60, and then a short recovery to 65. If the recovery fails to reach or surpass the previous high of 70 before going down again, the earlier relative low point of 60 become the failure-swing point. Should the RSI continue on that same downward trend and drop below 60, that is the time to sell. In simple terms, daily losses are just starting to outpace daily gains.

The reverse takes place at the lower end of the RSI scale, with upward trends that pass a previous relative high point indicating that it is time to buy. In that case, daily gains are beginning to outpace daily losses.
The RSI is an excellent early indicator of momentum changes, but it can fail in extremely strong or extremely weak markets that may blow past previous trends. This is where outside corroborating analysis becomes necessary – is there a reason for the strong momentum, such as a strong new product introduction or pending regulatory problems?

Using the RSI as your only investing tool is like having only a hammer in your toolbox – it works great whenever nails are involved but it does not work so well to fix your TV or computer. Make sure you view your RSI analysis within a broader market context.

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