RSI - Relative Strength Index

Relative Strength Index Definition

The Relative Strength Index (RSI) is one of the most popular indicators in the market. If you look over any market technician's shoulder there are a few indicators that show up quite frequently: MACD, Simple Moving Average, Volume and last but not least the RSI.

Relative Strength Index Formula

The RSI was developed by J.Welles Wilder and detailed in his book New Concepts in Technical Trading Systems in June of 1978. For all you hardcore technicians, below is the formula to calculate the RSI:

Relative Strength = Average positive price change over "x" periods
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Average negative price change over "x" periods

RSI Indicator is calculated as follows:

100
RSI = 100 - --------
1 + RS

The default setting for the RSI is 14 days, so you would calculate the formula as follows:

Relative Strength = 1.25 (Avg. Gain over last 13 bars) +. 25 (Current Gain)
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.75 (Avg. Loss over last 13 bars) + 0 (Current Loss)

Relative Strength = 1.50/.75 = 2.25

RSI = 100 - [100/(1+2.25)] = 69.23

Now that we know the formula, let's analyze how to actually use this powerful indicator. Most traders use the RSI simply by buying a stock when the indicator hits 30 and selling when the indicator hits 70. If you remember anything from this article, remember that if you buy and sell based on this strategy "YOU WILL LOSE MONEY". The market does not reward anyone for trading the obvious. Now that doesn't mean that simple methods don't work, but simple methods that everyone else is following have really low odds.

Psychology Behind the Relative Strength Index Double Bottom Signal

The first price bottom is made on heavy volume, which occurs after the stock has been in a strong uptrend for some period of time. This is the reason as mentioned below, that the RSI has been above 30 for a considerable amount of time. After the first price sell off, which also results in a breach of 30 on the RSI, the stock will have a snap back rally. This rally is short lived and is then followed by another snap back reaction which breaks the low of the first bottom. This second low is where stops are run from the first reaction low. Shortly after breaking the low by a few ticks, the stock begins to rally sharply. This second low not only forms a double bottom on the price chart, but the RSI as well. The reason this second rally has legs is for (1) the weak longs were stopped out of their position on the second reaction, and (2) the new shorts are being squeezed out of their position. The combination of these two forces produces sharp rallies in a very short time frame.

Using the RSI correctly

Many users of the RSI incorrectly assume that you should buy stocks with the highest relative strength. This key to using the RSI is to find stocks that are just breaking out of a sideways range with relative strength compared to the indices. The time to sell a stock is when the stock has advanced significantly out of that base with an overbought RSI reading.

Day Trading with the Relative Strength Index

The key components you want to see in a valid RSI bottom are the following:

• Double bottom (RSI hits at or below 30 twice within 1 hour of each bottom)
• High volume on first price bottom
• The first bottom on the RSI is the first touch of 30 or less on the RSI in the last 39 bars (represents half a trading day on 5-minute chart...feel free to change the bar interval to reflect your trading timeframe)

Relative Strength Stop Placement

With all trades you must use proper risk management, so stops are crucial. You will want to put your stop about .2 -.4% below the second bottom of this formation. In theory, if the squeeze has begun, the stock has no business breaching the second bottom's low.

RSI Profit Targets

Traders should keep a close eye on time & sales to see when the tape begins slowing down, to exit either half or all of the position. Remember, the reaction off of a RSI double bottom is sharp and fast.