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 lets 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 its 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
it -- is something quite different. Because of the similarity of its name with
term relative strength, the value actually depicted by the RSI is often
misunderstood by those lacking a real understanding of this indicator.
The RSI is a momentum indicator that measures the internal strength of a stock
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
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
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
Once youve settled on your time period, you simply plug it into your
Heres 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 youve chosen. Similarly, the sum of all losses divided by
your chosen time period gives you your average loss. Then, divide the average
by the average loss. Finally, the resulting value is smoothed using the previous
periods average gain and average loss (the smoothed RS calculation).
Math not your relative strength? Not to worry. You dont need to know how to
calculate RSI. But knowing how its 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
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. Youll be the life the party
(lampshade not included).
OK, now that weve mastered all of the intricacies of the RSI formula, lets see
what youre 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
bear markets, respectively. Thus, the RSI helps you pinpoint momentum extremes
and helps you locate turning points.
Now, lets 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
tool works all the time.
Thats 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
effect on your efforts -- you run the risk of constantly second-guessing
-- 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
My second reason for using the word assist is that the RSI is normally not
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 Ive received from
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
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, lets look at an example of buying a stock. The principle is
the reverse when shorting a stock or index.
Assume that youre interested in purchasing shares of Tulip Fever (BULB). Again,
a stock is considered oversold when the RSI falls below 30. If the RSI then
back above 30, thats 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
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
or index. Then you wait for the RSI to cross back above 30, if buying -- or slip
below 70, if shorting.
For example...Lets 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. Thats whats known among market
technicians as a divergence. Now, keep in mind that a higher low in the RSI
that -- based upon its recent closing prices -- the stock is exhibiting a
degree of relative strength compared to the stocks earlier (higher) low. Thus,
the RSI is telling you that BULB is not as weak that the stocks price action
appears to suggest.
If this scenario plays out as I just described, heres what you do: Wait for the
RSI to rise back above 30. Now, consider what has just happened. You have a
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.
entry signal would be the RSI subsequently dropping below the 70 (overbought)
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
to be bearish. It sounds simplistic, but its not, because the RSI is best used
a complementary tool.
And thats 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 Im examining
confirm the strength of that momentum -- by crossing above or below the 50
This way, Im only acting upon confirmed trading signals, thereby increasing my
odds of success.
But I dont act even after this confirming signal from the RSI. I use a third
confirming indicator that...Ah, but it seems were 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 youre not yet using the RSI to assist you in your buy or short entry
decisions, give it a try. None of the methods Ive described is terribly
complicated, and any one or all might help you buy or short a stock -- or
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.