Relative Strength Index (RSI)

The relative strength Index (RSI) is a momentum indicator, or oscillator was developed by Welles Wilder to measures the relative internal strength of a security against itself.

The Relative Momentum Index (RMI) and Change momentum oscillator (CMO) both are another variation on the RSI. The following topics start with introduction to relative strength Index (RSI) indicator and how to interpret relative strength index (RSI) such as overbought and oversold signal and setting up with difference time span to adjust the sensitivity of the indicator react to the changes. Finally, Change Momentum Oscillator (CMO) and Relative Momentum Index (RMI) are explain as an alternative to relative strength index (RSI).

The relative strength Index (RSI) was developed by Welles Wilder. It is a momentum indicator, or oscillator, that measures the relative internal strength of a security against itself. This should not be confused with comparative relative strength, which compares the performance of one security to another.

The Relative Strength Index (RSI) Formula

The formula for the Relative Strength Indicator (RSI) is as follows:

RSI = 100 ­ 100 / (1 + RS)

RS = average of x days' up closes / average of x days' down closes

Where RS = the average of x days' up closes divided by the average of x days' down closes. The formula aims to overcome two problems involved in the construction of a momentum indicator: (1) erratic movements and (2) the need for a constant trading band for comparison purposes. Erratic movements are caused by sharp alterations in the values, which are dropped off in the calculation.

For example, in a 2O-day rate of change (ROC) indicator, a sharp decline or advance 20 days in the past can cause sudden shifts in the momentum line even if the current price is little changed. The RSI attempts to smooth out such distortions.

The RSI formula not only provides this smoothing characteristic, but also results in an indicator that fluctuates in a constant range between 0 and 100. The default time span recommended by Wilder is 14 days, which he justified on the basis that it was half of the 28-day lunar cycle.

 

Relative Strength Index (RSI) Interpretation

Extreme Readings and Failure Swings. Any time an RSI (Relative Strength Index) moves above its overbought zone or below its oversold zone, it indicates that the security in question is ripe for a turn.

Extreme Readings and Failure Swings. Any time an RSI (Relative Strength Index) moves above its overbought zone or below its oversold zone, it indicates that the security in question is ripe for a turn. The significance depends upon the time frame under consideration. An overbought or oversold reading merely indicates that, in terms of probabilities, a countered action is over­done or overdue.

It presents an opportunity to consider liquidation or acquisition, but not an actual buy or sell signal. This can come only when the price series itself gives a trend-reversal signal.

For instance, if a security is overbought and was confirmed by a nice trend break in the price. Compare to the oversold reading that was not confirmed by a price break and did not generate any meaningful rally.

More often than not, the RSI (Relative Strength Index) traces out a divergence. These divergences are often called failure swings.

 

RSI Overbought/Oversold Lines

The RSI (Relative Strength Index) Enables accurate Comparisons of different Securities on the same chart. The longer the time span, the narrower the RSI (Relative Strength Index) overbought and oversold lines should be constructed and vice versa.

The default time span for the calculation of an RSI (Relative Strength Index) is 14 periods. The overbought and oversold lines are typically drawn at 70 and 30, respectively. This research would indicate that the 70 and 30 levels recommended by Wilder should be moved farther apart to better reflect the average overbought and oversold values.

It is important to note that the magnitude of the oscillations of the RSI (Relative Strength Index) is inverse to that of most other momentum series. For example, the ROC indicator is subject to wider fluctuations the longer the time span. It works in an opposite way for the RSI (Relative Strength Index). For the RSI (Relative Strength Index), equilibrium is the halfway point, which in this case is the 50 level. It is therefore traditional to place the overbought and oversold lines equidistant from this point.

We should remember that longer time spans in the RSI (Relative Strength Index) calculation result in shallower swings and vice versa. Consequently, the 70/30 combination is inappropriate when the time span differs appreciably in either direction from the standard 14-day period.

The terms long and short time spans refer to the type of data under consideration in a relative sense. For example, a 60-day RSI (Relative Strength Index) would represent a long span for daily data, but for monthly numbers, a 60-day (2-month) span would be very short. Some consideration should therefore be given to this factor when the choice of a specific RSI (Relative Strength Index) time span is being made.

Because RSI (Relative Strength Index) based on shorter-term time spans experience greater volatility, they are more suitable for pointing out overbought and oversold conditions. On the other hand, longer-term spans are more stable in their trajectories and therefore lend themselves better to the purpose of constructing trend-lines and price patterns.

 

RSI Relative Strength Index Time Span

The RSI (Relative Strength Index) can be plotted for any time span, the default for most charting packages is 14-day time span selection.

The maximum divergence occurs when the moving average (MA) is exactly half the time span of the dominant cycle. In other words, if you make the assumption that the primary trend of the stock market revolves around the 4-year business cycle, an MA of 24 months will give you the greatest divergence between the high and low points of the cycle.

In the case of the 28-day cycle, 14 days is the correct choice, but it is important to understand that there are many other cycles apart from the lunar cycle. Working on this assumption, for example, would mean that a 14-hour RSI (Relative Strength Index) would be inappropriate if the dominant cycle was something other than 28 hours. The same would be true for weekly and monthly data.

In practice, a 14-day time span works quite well, but only for shorter peri­ods. I also use 9-, 25-, 30-, and 45-day spans. For weekly data, the calendar quarters operate effectively, so 13-,26-,39-, and 52-week spans are adopted. As for monthly charts, the same recommended spans for the ROC are also suitable for the RSI (Relative Strength Index), that is, 9, 12, 18, and 24 months.

For longer-term charts, covering perhaps 2 years of weekly data, a time span of about 8 weeks offers enough information to identify intermediate term turning points. A 26-week RSI (Relative Strength Index) results in a momentum series that oscillates in a narrower range, but nevertheless usually lends itself to trend-lines construction. Very long term charts, going back 10 to 20 years, seem to respond well to a 12-month time span. Crossovers of the 30 percent oversold and 70 percent overbought barriers provide a very good indication of major long-term buying and selling points. When the RSI (Relative Strength Index) pushes through these extremes and then crosses back toward the 50 level, it often warns of a reversal in the primary trend.

To isolate major buy candidates, it is important to remember that the best opportunities lie where long-term momentum, such as a 12-month RSI (Relative Strength Index), is oversold. If you can also identify an intermediate and a short-term oversold condition, all three trends, primary, intermediate-term, and short-term, are then in a classic conjunction to give a high-probability buy signal.

 

Smoothing RSI and Trend-line Violation

trend-lines Violations and Pattern Completions The RSI can also be used in conjunction with trend-lines violations. Generally speaking, the longer the time span for any particular period (daily, weekly, or monthly), the better the opportunity for trend-lines construction.

Important buy and sell signals are generated when trend-lines for both price and the RSI are violated within a relatively short period. An example of the RSI's capability to form price patterns is three situations in which it traced out a head-and-shoulders (H&S) formation. Each one was confirmed by a trend break in the price. Note how the inverse pattern, formed involved several false oversold crossover buy signals. However, it was not until the pattern was completed that the price confirmed any of this by rallying above its 3-month down trend-lines.

Smoothing the RSI It is a perfectly legitimate technique to smooth the RSI. One of my favorite approaches is to smooth a 9-day RSI with an 8-day MA. Because the fluctuations are not as great as the raw data, the overbought and oversold lines are drawn at 70 and 30, not at my usual default of 80/20 for a 9-day span.

This smoothing technique is very useful from the point of view of flagging reversals when the indicator moves beyond its normal overbought and oversold extremes. This form of interpretation works pretty well except in periods experiencing strong linear up- or downtrends.

 

Change Momentum Oscillator (CMO) and Relative Momentum Index (RMI)

 


 
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