How many indicators does technical analysis have? Simply put, too many indicators to count, and most charting software will give you the option of customizing existing ones or creating your own. However, the situation was different 33 years ago in 1978, when J. Welles Wilder (engineer, turned real estate developer, turned technical analyst) self-published his book New Concepts in Technical Trading Systems. At the time, there were only two technical indicators (moving average and weekly rule) and Wilder’s book introduced four new ones. It is not surprising that the author was able to sell tens of thousands of copies worldwide. This is probably another reason why technical analysts enthusiasts are well familiar with Wilder’s relative strength index (RSI) and average true range (ATR).
Relative Strength Index (RSI) is the first momentum indicator or oscillator. Momentum refers to the speed at which a stock or commodity price rises or falls. Momentum can point out hidden tendencies within a trend and adapts to the fact that up moves trends take a longer time to develop and down trends take less, meaning that prices fall faster than they rise. In a nutshell, relative strength index refers to a market’s strength against itself. I like to think about it as a ‘doping meter’: is this stock on steroids or just following the trend of the overall market? Some people confuse RSI with relative strength (RS). The latter measures the correlation between two securities, for example two stocks in your portfolio.
RSI At a Glance
The default time span for most charting software is identical with the one recommended by Wilder, 14 days or periods. The formula for RSI is:
RSI = 100 – 100/(1+RS) where
RS = average of x days’ up closes or periods/average of x days’ or periods’ down closes
Luckily, you don’t have to worry about memorizing it, the most important thing to remember is what it measures and possible ways to profit from using it.
RSI is displayed on a scale from 0 to 100, with overbought default value of 70 and oversold default value of 30. Alike any other oscillator, RSI is not intended to be used alone, it is rather a confirming type of indicator. RSI’s main purpose is to point out overextended market conditions. For example, an RSI reading above 70 could mean sell and a reading below 30 could mean buy.
RSI – Conflicting Views
The AUDUSD (Australian Dollar/ US Dollar pair) daily chart below (from 2010, five years ago) – shows RSI plotted with the standard parameters: 14 days, 70/30 overbought & oversold levels.
As you can see the reliability of the oscillator is questionable. The first vertical line is drawn when RSI exceeded the overbought level of 70, in September 2010, but the uptrend continued very strongly for another month, before a modest pullback finally happened – see second vertical line. The third vertical line, when RSI revisited the 70 levels in November 2010 was a more reliable indicator of a sell-off.
Over the years, traders have found new interpretations and parameters for the old RSI. Richard Tortoriello argued that RSI is just another measure of “relative strength”, and a stock should be held if RSI value is high instead of sold. Therefore a low RSI reading means that the trend is weak and you should consider staying on the sidelines or selling the stock if you own it. According to Tortoriello’s research on stocks from 1992 to 2007, buying stocks with high RSI produced an average annual return of 16.7 percent compared to S&P 500 return for the same period of 11.1 percent. Moreover, Tortoriello’s portfolio experienced better returns than the market approximately 70 percent of the time. Another key difference is that Tortoriello uses RSI as an intermediate time frame oscillator, calculated on 28-week period, rather than 14-day period. This is another significant divergence from Wilder’s view of RSI as a short time frame oscillator.
There were some other changes introduced to RSI: the overbought/oversold values. Some argued that the 70/30 is too arbitrary and broad, therefore the threshold should be adjusted according to market conditions. Andrew Cardwell – market researcher and president of Cardwell Financial Group Inc. – noticed that during a bull market an appropriate overbought level for the daily chart is 80 and 40 for oversold. For bear markets Cardwell prefers 60/20 readings. The purpose of using 80/40 and 60/20 according to market conditions is to receive fewer but more reliable sell signals during uptrends and more buy signals during downtrends, therefore eliminating whipsaws. Of course, the key is to determine on time the current state of the market. The overbought/oversold parameters need to be adjusted according to the time frame. For example, 70/30 RSI values on weekly are very hard to come buy.
Below is a sample AUDUSD weekly chart from five years ago, with RSI plotted on a 28-week period and overbought/oversold readings of 60/20. As you can see from observing the horizontal lines, pullbacks and changes in trend are signaled more accurately, although there is some time lag between the time RSI’s value reaches the overbought territory and the sell-off actually happens. This is why it is very important to use RSI in combination with other indicators.
Since RSI has been around for more than 30 years, traders had time to research, develop and publish variations of it. So far there are two main RSI-based indicators. One of them is Chande Momentum Oscillator (CMO), named after its developer Dr. Chande. The indicator displays overbought and oversold conditions more often and the scale is between -100 and 100 with an equilibrium point at 0, making it easier to read. Relative Momentum Index (RMI) is the second one and also displays overbought and oversold values more often, being more appropriate for shorter time frames.
Even though Technical Analysis of Stocks and Commodities named Welles Wilder one of the “heroes of technical analysis”, his oscillator – relative strength index – has a confusing name and its default parameters are not very reliable. We have to give credit to Mr. Wilder though for publishing one of the first and most successful books on technical analysis and opening the door for momentum indicators.