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Relatively Speaking, It's a Simple Indicator

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While far from perfect, RSI, the relative strength indicator, remains a favorite indicator. Its calculation is relatively easy to understand and its use it, too. Some aspects of the indicator deserve more than casual attention, however.

A chart demonstrates some of those aspects.

Annotated Daily Chart of the Crude Contract for March Delivery:

The indicator's name sometimes causes difficulties because it suggests that strength is being measured relative to the strength of another entity. That's not true. On the chart of the crude contract, for example, RSI measures the strength of price action of that contract against its own past performance over 14 periods. Most traders refer to this indicator by its acronym, RSI, and this helps to avoid confusion.

As mentioned earlier, the computation proves easy. The explanation takes longer than the computation would. Although almost every charting service offers RSI and few traders will ever calculate it, an examination of the formula promotes a better understanding of how the indicator works and what it shows.

To calculate RSI, figures called "average gain" and "average loss" are first computed. These have been placed in quotation marks because their names are misnomers. For the purpose of calculating RSI, average gain equals (total gains over a period of n observations)/n, rather than total gains divided by the number of periods in which there were gains. Average loss equals (total losses over a period of n observations)/n rather than total losses divided by the number of periods in which there were losses.

A figure called RS is calculated by dividing the calculated average gain by the calculated average loss. Obviously, if prices are climbing, more periods produce gains, and RS is higher than if prices are dropping and more periods produce losses.

RS is used in the computation of RSI, with the formula as follows:

RSI = 100 - [100/(1 + RS)]

The larger RS is, the smaller that second term [100/(1 + RS)] will be. RSI will move closer to 100. The smaller RS is, the larger that second term will be. RSI will move closer to 0.

Most charting services then use a smoothing factor. Using 50 as a benchmark, traders can then determine that if RSI is above 50, average gains outstrip average losses and price action has a bullish tenor. If RSI is below 50, average losses outstrip average gains, and price action has a bearish tilt. RSI that squiggles around 50 tells traders that no trend has been established. Some traders are reluctant to enter a trade either direction with RSI chopping around near 50.

That smoothing factor mentioned in the previous paragraph is necessary because RSI can be somewhat jerky. One of the reasons that traders like this indicator is that it sometimes tends to lead price action more than other indicators might, but that also means that false signals sometimes occur, and the smoothing helps.

Because RSI sometimes leads price action but also sometimes gives false signals, few traders use RSI alone to signal trades. It offers a great heads-up that a trade may be developing, but its characteristics argue against entering trades based on RSI evidence alone.

Some traders tinker with the interval and overbought and oversold settings, depending on the security being watched or the presence of a trend. Although chart default settings for overbought and oversold levels are usually 30 and 70, traders can often reset them to 20 and 80 or even 10 and 90. Traders watching a stock, future or index that's trending higher might want to employ that 80 setting before prices are considered overdone to the upside, while traders watching a stock, future or index that's trading lower might want to use 20 before prices are considered overdone to the downside.

Annotated Daily Chart of the SOX:

An interesting article appeared in the February issue of STOCKS AND COMMODITIES. In that article, author David Sepiashvilli attacked the problem of creating a self-adjusting RSI that he claims adjusts itself to price movements across many periods. He uses a number of standard deviations from 50 as a benchmark of overbought or oversold conditions rather than using a number of points away from 50. He argues that when relying on a number of points away from 50 in the standard setup for RSI, periods lower than 14 often provide too many overbought or oversold readings while those longer than 14 may provide too few. RSI may narrow so much that no overbought or oversold readings are given if long intervals are chosen. His article describes the steps he used to develop his indicator and the way he uses it, for those interested in pursuing that option in more depth.

For the rest of us using the normally calculated RSI, further uses include identifying bearish and bullish divergences. Another peculiarity of the RSI is that its chart formations can sometimes be more important than its actual levels. To see what's meant by this, it's time to take a second look at that chart of the crude contract.

Annotated Daily Chart of the Crude Contract for March Delivery:

This last use of RSI makes it a favorite among many traders, including this writer. The neckline break on the RSI H&S provided the heads-up that matters were growing much more bearish. The subsequent price breakdown below the January 17 or 25 lows, or the retest that occurred on February 6, depending on trading style, would have been the price confirmation.

The same disclaimer that is appended to all articles about indicators can be added to this one. RSI offers a heads-up, and sometimes an early enough one that traders have time to prepare an entry plan, but that early signal comes with a price: false signals. This is particularly true, of course, of any countertrend signal that RSI might give. Don't use RSI alone as a reason to enter or exit a trade, but do use it as a tool to prepare trading plans and then to execute them if prices trigger an entry or exit according to your plan.
 

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