Analytical Toolbox: Relative Strength Tools
December 13, 2007
Relative strength tools are comparative tools that are used for a group of markets or securities, or an individual security. They include:
- Relative Ratios (Relative Strength Comparisons)
- Rate of Change Rankings and
- Relative Strength Index [RSI]
RSI
Developed by Welles Wilder Jr., the RSI is a momentum tool that is available on most technical charting applications. Andrew Cardwell and Constance Brown are two technical analysts who have extensively studied and applied the tool (see the end of the article for some books you may want to check out). A recent topic on my discussion board (under ‘Indicators’) also identifies resources to consider from other traders.
The RSI measures current price movement for a security relative to its movement a certain number of periods ago. Assuming RSI is applied to a daily chart, the default setting for the tool uses a 14-day period to assess movement. This is accomplished using a Relative Strength [RS] factor comprised of upward movement and downward movement that is calculated as follows:
RS = [(Sum of Up Closes over 14-days) / 14]
[(Sum of Down Closes over 14-days) / 14]
RSI = 100 – [100 / (1 + RS)].
It pays to go to the source—these equations are taken from Wilder’s 1978 book, New Concepts in Technical Trading Systems. I’ve been mistaken in the past thinking the numerator was divided by the number of up days and the denominator was divided by the number of down days. In terms of applying the tool, such a nuance would not matter, but if you wanted to program the tool or use the principal that drives it to develop your own tool, it will matter.
The up and down closes are changing values for the security. Rather than a true average using the total number of days with up or down closes, each RSI sum is divided by the indicator period of 14. Although the factor of (1/14) ÷ (1/14) cancels out when completing the RS calculation on the first day, Wilder used this approach so he could more easily calculate the next day’s result, pre-computer. According to Wilder, he developed RSI to normalize momentum values so he could easily apply one tool to different commodity markets. He also wanted to address a deficiency in the Momentum indicator, which plots: Today’s Close – Close from x-days ago.
Consider a 14-day Momentum Indicator movement with yesterday’s close $2 below the close from 15 days ago and today’s close $2 below the close from 14 days ago. The Momentum Indicator would remain flat since there is no change in the rate of decline for the security, even if the current day included up or downward movement. However, in order for RSI to remain flat the RS for today would have to equal the RS from yesterday. This only happens if the up or down movement from today was the same as the up or down movement from 14-days ago. At that point, the indicator is properly measuring the relative strength between the two periods.
Wilder’s Applications
Wilder identified five applications for the RSI including:
- RSI tops and bottoms that lead price tops and bottoms,
- RSI chart formations that bring attention to price formations,
- Failure moves in RSI (especially above 70 or below 30) that warn of price failures,
- Identification of RSI support & resistance to identify price support & resistance, and
- Alerts of pending directional change for price when RSI diverges
Applications 3 and 5 are likely the most commonly used; however, see if you can bring up a few different price charts with the RSI indicator to identify the others.
Brown’s Applications
Constance Brown’s book identifies two additional techniques for applying RSI. They include:
- Identification of bullish and bearish zones for the indicator and
- Bullish and bearish reversal formations with projection implications.
Brown became so familiar with RSI movement that she noted when the default setting is used (14) the indicator tends to move in a bullish range when price remains in a bullish trend and in a bearish range when price remains in a bearish trend. So, a price decline after a recent market high favors a continued bullish trend when RSI successfully tests its bullish support zone (40-50). Conversely, a bottom may yet to be reached when price rises from a recent bottom as RSI bearish resistance (55-65) successfully holds. Note that rather than a specific support or resistance value for RSI, a ten point region is identified.
Using a monthly chart for the Dow Jones Industrial Average ($INDU), check the area in which RSI travels when a bull market or bear market is in place. Also note to what extent the indicator leads the index value. Brown’s bullish zones are identified as (40-50) for support and (80-90) for resistance. The bearish zones are (20-30) for support and (55-65) for resistance.
Sadly, my laptop crashed last week and I have yet to get up and running with another. Hence, I can’t provide images this week so I’ll save the sample charts with RSI reversals for next week.
Clare White
Contributing Writer and Options Strategist
Optionetics.com ~ Your Options Education Site
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Books: J. Welles Wilder, Jr., New Concepts in Technical Trading Systems (1978)
Constance Brown Technical Analysis for the Trading Professional (1999)
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