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. The RSI is a basic measure of how well a stock is performing against itself by comparing the strength of the up days versus the down days. This number is computed and has a range between 0 and 100. A reading above 70 is considered bullish, while a reading below 30 is an indication of bearishness.
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 relative strength index formula:The default setting for the RSI is 14 days, so you would calculate the relative strength index formula as follows:
Relative Strength =
1.25 (Avg. Gain over last 13 bars) +. 25 (Current Gain) / (.75 (Avg. Loss over last 13 bars) + 0 (Current Loss))
Relative Strength = 1.50 / .75 = 2
RSI = 100 – [100/(1+2)] = 66.67
Now that we know the relative strength index formula, let’s analyze how to actually use this powerful indicator. Most traders use the relative strength index 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 relative strength index 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 relative strength index formula 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 relative strength index 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 time frame)
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.