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Relative strength index

Relative strength index (RSI) is a technical indicator used in the analysis of financial markets. This is a measure of the price trend of a stock or other financial instrument compared to another stock, instrument or industry. It is calculated by taking the price of one asset and dividing it by another.

E.g., if the price of Ford is $7 and that of GM shares is $25, the relative strength of Ford to GM is 0.28 ($7/25). This number is given context when it is compared to the previous levels of relative strength. If, the relative strength of Ford to GM ranges between 0.5 and 1 historically, the current level of 0.28 suggests that Ford is undervalued or GM is overvalued, or a mix of both. The reason we know this is because the only way for this ratio to increase back to its normal historical range is for the numerator (in this case the price of Ford) to increase, or the denominator (in our case the price of GM) to decrease. It should also be noted that the ratio can also increase by combining an upward price move of Ford with a downward move of GM. E.g., if Ford shares rose to $14 and GM fell to $20, the relative strength index would be 0.7, which is near the middle of the historic trading range.

It is by comparing the relative strengths of two companies that a trading opportunity, known as pairs trading, is realized. Pairs trading is a strategy in which a trader matches long and short positions of two stocks that are perceived to have a strong correlation to each other and are currently trading outside of their historical relative strength range. For example, in the case of the Ford/GM relative strength at 0.28, a pairs trader would enter a long position in Ford and short GM if he or she felt the pair would move back toward its historical range.



RSI momentum

Every book dealing with the subject of technical analysis devotes at least a couple of chapters discussing both momentum and relative strength index (RSI).

For those of you not familiar with price momentum and the relative strength index, you need to know that J. Welles Wilder first wrote about the subject in the classic "New Concepts In Trading Systems".

To understand how these two indicators can be used together, we must first for a moment review each of them. RSI momentum is the measurement of the speed or velocity of price changes. In "Technical Analysis of the Financial Markets", John J. Murphy explains:

"Market momentum is measured by continually taking price differences for a fixed time interval. To construct a 10-day momentum line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line. The formula for momentum is:

M = V - Vx
V is the latest price, and Vx is the closing price x number of days ago."

RSI momentum measures the rate of the rise or fall in stock prices. From the standpoint of trending, momentum is a very useful indicator of strength or weakness in the issue's price. History has shown us that RSI momentum is far more useful during rising markets than during falling markets; the fact that markets rise more often than they fall is the reason for this. In other words, bull markets tend to last longer than bear markets.

For relative strength, determining the true value of an oscillator depends on the understanding of overbought or oversold positions. There has always been a little confusion over the difference between relative strength, which measures two separate and different entities by means of a ratio line, and the relative strength index, which indicates to the trader whether or not an issue's price action is created by those over-buying or over-selling it. The well-known formula for the relative strength index is as follows:

RSI = 100 - 100 / (1 + RS)
RS = Average of x days' up closes Average of x days' down closes

At the bottom of the chart, the RSI, on a scale of 0-100, indicates that the overbought position is at 70 and the oversold position is at 30. An trader with today's simple-to-use software may choose to reset the indicators' parameters to 80 and 20. This helps the trader be sure when making the decision to buy or sell an issue and not pull the trigger too fast.

I have always found that the Relative strength index works best when compared to short-term moving-average crossovers. Using a 10-day moving average with a 25-day moving average, you may find that the crossovers indicating a shift in direction will occur very closely to the times when the RSI is either in the 30/70 or 20/80 range, the times when it is showing either distinct overbought or oversold readings. Simply put, the RSI forecasts sooner than almost anything else an upcoming reversal of a trend, either up or down.


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