The Relative Strength Index (RSI) can help investors and traders plough their way through sideways markets and is a very helpful tool in stock market technical analysis. In the previous chapters, we have discussed trend-following indicators. Now we begin a discussion on momentum oscillators. This will be continued in Chapter 7: Stochastic Oscillator, when we discuss the stochastic, and also in chapter nine, when we examine the MACD histogram.
Two Uses of Momentum Oscillators
There are two ways we can use momentum oscillators. One is to trade sideways (ranging) markets. The other is to trade trends.
Momentum oscillators were invented primarily for the first purpose. In sideways markets, we try to buy when the price falls to a support level, where buyers come in to overcome selling pressure, and to sell when the price rises to a resistance level, where sellers emerge and overcome buying pressure.
Diagram 6-1 shows conceptually how we would try to trade a sideway market.
Momentum oscillators tend to mimic the price in sideways markets. This might lead us to think they are of limited use, were it not for three characteristics of momentum oscillators.
Momentum refers to the speed at which a price is changing. The simplest way of measuring it is to compare how much the price has changed from one period to another.
The first is that they sometimes turn slightly before price. The second is that it is often easier to see deterioration in the momentum on the oscillator than on the price. The third is that momentum oscillators can be designed to make it easier to see overbought and oversold levels than on the price chart.
Although their primary use it in sideways markets, momentum oscillators are also very useful in trading trends. Traders can buy and sell peaks and troughs of the trend.
Diagram 6-2 shows conceptually how a trader would be trying to trade a trend. It can be seen from the dotted lines that delineate a trend channel that conceptually a trend can be like an up-sloping (or down-sloping) ranging market.
Investors will attempt to enter trends early and stay with the trend while it persists. However, sometimes investors will try to enter a trend that is running strongly. Momentum oscillators can be an excellent tool for this purpose. Investors will use the traders’ buy signals to buy into such a trend. This is the primary use for investors, though momentum oscillators can also provide some useful confirmation of trend-ending signals, which are given by trend-following indicators.
Momentum refers to the speed at which a price is changing. The simplest way of measuring it is to compare how much the price has changed from one period to another. So, if the price last Friday was $1 and this Friday is $1.10, we can say that the price is changing at the rate of 10cent per week, or 2 cent per day. If the price next Friday is $1.30, then we would say that the momentum has increased, because the price has gone up at a rate of 10cent per week last week, but at a rate of 20cent per week in the following week.
Calculating momentum in this way is the basis of a common momentum oscillator, and is simply called momentum.
Rate of Change
Another common momentum oscillator is the rate of change and it is the price in this period divided by the price last period.
The momentum and rate of change are surprisingly effective indicators. The one difficulty with them is that they fluctuate above and below zero with no fixed boundaries, so that overbought and oversold levels have to be determined empirically on each chart.
The Relative Strength Index (RSI) developed by J. Welles Wilder Jr, is probably the most popular momentum oscillator and is available in most charting software packages. It differs from the momentum and rate of change in two ways. First, it measures momentum in a different way. Second, its formula causes it to fluctuate only between zero and 100.
RSI is usually plotted as in chart 6-1, where it is a line in a sub-chart below the price chart. A sub-chart is used primarily because the scale is not the same as for price.
How Relative Strength Index (RSI) is Calculated
The method of calculation is quite complex. RSI takes a period of, say, 14 days, and determines for each day whether the closing price is up, down or unchanged. All the up closes are recorded and the increases totaled and divided by 14. Then the down closes are recorded, the decreases totaled and divided by 14. RSI is a ratio between the average increases and the average decreases, made to fluctuate between zero and 100 and smoothed mathematically so the indicator does not jump around too much.
If 14 days were taken as the period and every day the price was higher than the day before, RSI would be 100. The closer it is to 100, the more overbought the upward trend is. If every day was down, RSI would be zero. The closer it is to zero, the more oversold and downward trend is.
Overbought and Oversold Levels
The general practice is that a RSI above 70 represents an overbought level and oversold is below 30. These lines are often marked on the chart by the software. However, they need some adjustment for the market conditions. In a sideways market, these standard settings will generally be accurate. In a trending market, RSI will be biased to one extreme.
- In an uptrending market, RSI will tend to be biased upwards, so that 40 and 80 may be better choices. Chart 6-1 shows a seven-day RSI below a daily bar chart. The RSI fell only once below the 30 line, but rose several times above 80.
- In a downtrending market, RSI will tend to be biased downwards, so that 20 and 60 may be better choices. Chart 6-2 shows a seven-day RSI below daily bar chart. The RSI only rarely rose above 70, but several times fell below 20.
The longer the period over which the RSI is calculated, the less volatile the line will be.
This makes it especially important for investors, who many use a 14-day or a 14 –week RSI, or longer, to raise the oversold level to 40 in an uptrend. Otherwise, RSI will not generate many signals and some good buying opportunities will be missed.
Welles Wilder introduced a new concept of failure swing, which is needed in interpreting RSI. A failure swing occurs when:
- The RSI swings above the overbought level, and then falls. The next upward swing finishes lower than the first one. The failure swing is complete when the RSI falls below the low point of the fall registered after the initial peak.
The left hand side of diagram 6-3 shows this configuration. The second peak here is shown to be above the overbought line. This is not essential, but is a stronger signal.
- The RSI swings below the oversold level, and then rises. The next down-ward swing finishes higher than the first one. The failure swing is complete when the RSI rises above the high point of the rise after the initial trough.
The right hand side of diagram 6-3 shows this configuration. The second trough here is shown to be below the oversold line. This again is not essential but is a stronger signal.
Rules for Using RSI in a Sideways Market
- Rule 1: Buy when the RSI has fallen below 30 and rises back above it.
Chart 6-3 shows a tight sideways movement on a daily bar chart of Funtastic. Because the sideways movement is not very deep, a five-day RSI is used to try to get early signals. The buy signals using rule 1 are shown as red dotted lines.
These mark the day of the signal. Action would be taken the next day. However, because the range from high to low in the sideways movement is not very great, some of these signals may not have been very profitable.
- Rule 2: Sell when RSI has risen above 70 and falls back below it.
Chart 6-4 shows the same sideways movement on Funtastic, again with a five-day RSI. The sell signals using rule 2 are shown as red dotted lines. These mark the day of the signal. Action would be taken the next day.
- Rule 3: Buy divergences where the first trough on RSI is below 30. If the divergence forms a failure swing on the RSI, it is an even stronger signal. Chart 6-5 shows a good example on the daily bar chart of Colorado.
- Rule 4: Sell divergences where the first peak on RSI is above 70. If the divergence forms a failure swing on RSI, it is an even stronger signal.
Chart 6-4 shows an example on Funtastic at the first sell signal marked in April. This one did not carry through until after a further rule 2 sell signal was given.
Rules for Using RSI in a Trending Market
- Rule 1: In an uptrend, buy when the RSI falls below the oversold line and crosses back above it. If the signal is in the form of a failure swing on the RSI, it is an even stronger signal. In this situation, it will be appropriate to use 40 as the oversold level. Chart 6-1 shows several of the simple signals. Chart 6-6 is a close-up view of the stronger signal on chart 6-1 in June – July 2003.
- Rule 2: Use trend-following indicators to sell out of any uptrend. Divergence no the RSI may be used to take profits in an uptrend, but unless confirmed by a trend-following indicators, these are not likely to be the final peaks of the uptrend.
Chart 6-7 shows how an investor might use this rule. The chart is a weekly bar chart of Westfarmers. On it is a 26-week moving average and below it a seven-week RSI. In 2000, we see a clear divergence. Westfarmers stayed above the moving average, suggesting that this was a premature signal for a trend investor. In 2001 there are two consecutive divergences (sometimes called a triple divergence). In early 2002, Westfarmers begins to slip below the moving average, confirming these two divergences were foreshadowing the end of the trend.
There are many other ways that people use RSI. The rules given in this chapter seem to be the most effective. However, mention should be made of trend lines on the RSI itself.
Trend lines can be useful buy and sell signals in sideways markets, where they will often be associated with the signals described above, and provide additional comfort.
These lines can also indicate that the end of a trend is likely, but such a signal should be confirmed by a trend-following indicator, or it is likely to be only an intermediate peak in the trend.