If you are a stock trader or investor who is having trouble sleeping at night because you don’t know how to do the relative strength indicator calculation, then worry no more. You’ve come to the right place.
How relative is the strength?
The first point to clarify regarding the relative strength index, or indicator, is that it doesn’t measure the relative strength of a stock in the way we normally understand relative strength to mean.
The relative strength of a stock or a sector means that in a rising market, if the market is going up by say 2 percent and a particular stock or a sector goes up by 3 percent over the same period, then we say that stock or sector is showing relative strength.
Wait a minute, I hear the unimaginably astute reader who remembers something from an earlier article say, that sounds a lot like the beta.
Well spotted. But there is an important difference between relative strength and beta. Very simply, beta is a measure of the sensitivity of a stock to market movements in either direction, i.e. if the market moves up or down the stock price moves up or down in a fixed relation. Here is a detailed explanation of how beta works.
On the other hand, relative strength is concerned with which stocks or sectors are showing strength in relation to the market. So we are concerned with strength which is a measure of price gain of a stock or sector in relation to market price movement.
The difference between relative strength and beta is that in a rising market stocks with a beta greater than 1 will have high relative strength, whereas in a declining market, stocks with a beta less than 1 will have greater relative strength.
The Relative Strength Index or RSI
So what does the Relative Strength Index show? The answer is that it shows the strength or weakness in recent and current price movements of a stock.
The important and potentially confusing point here is that the index shows the current price movements of a stock in relation to recent price movements over a set period. What could be confusing is that the current price movement is only compared with recent price movements of the same stock and not with price movements of the market. So it is measuring the strength of its own price movements in relation to where the price has been.
The Relative Strength Index Formula
Before we get into the calculation here is the formula for the Relative Strength Index, where
- RSI = the relative strength index.
- K = the average of all upward price movements in the period.
- D = the average of all downward price movements in the period
Then the formula for RSI is:
OK so now we’ve got the definition out of the way let’s dive into the calculation itself. No worries, this will be more like a gentle wade into a kiddies paddling pool rather than a swan dive into the deep end.
The RSI calculation
The RSI is most usually used for a 14-day period. In this case, we need to know the closing price of the stock for the last 15 days. We then calculate the day on day price changes. From there we calculate the average of all the upward price moves and the average of all the downward price moves.
There are three kinds of averages used to calculate the RSI
- An exponential moving average, using exponential weighting
- A smoothing method used by Mr. J Welles Wilder the inventor of the RSI.
- A simple moving average proposed by Mr. Cutler
Here is a step by step calculation for the RSI for the 14-day period up to 26 June 2020 for the State Street Global Advisors Standard and Poor’s 500 index-tracking ETF which goes by the symbol SPY. This example uses a simple moving average calculation without smoothing.
The RSI as calculated in this case using a simple moving average, as proposed by Mr. Cutler, yielded an RSI of 31.16.
Here is a chart of the SPY for the same period.
We can see that on the chart the RSI for SPY on 26 June was calculated to be 45.14. This is because the chart uses Mr. Wilder’s method of smoothing the averages. The smoothing calculation used in the chart factors much less the very large price drop in the 12th figure of the series. Whereas in the simple moving average calculation that large price drop is given equal weight with the other price movements.
Over-bought and over-sold lines
The Relative Strength Index is usually displayed with a line at 70 indicating over-bought and a line at 30 indicating over-sold. When the RSI moves above 70 that is an indication that the stock could be over-bought and when it moves below 30 that is an indication that the stock could be oversold.
What does the RSI show?
The Relative Strength Index is just an indicator of price momentum. Let’s say this another way, it indicates where the current price is now in comparison to where the price has been over the last 14 trading days. This is sticking with the 14 day RSI period.
As already noted when the RSI is 70 or above the stock is considered to be in overbought territory and at 30 and below it is considered to be in oversold territory.
The RSI is considered to give a sell signal if it crosses from above 70 and moves consistently lower.
The reverse also applies. The RSI is considered to give a buy signal if it crosses from below 30 and moves consistently higher. Here is an example of the same ETF as considered earlier, the SPY for the period February to June 2020.
As we can see if we had only considered buy and sell signals from the RSI during this period we would not have made particularly good trading decisions. In fact, all through the first half of March 2020 when the market was tanking the RSI was giving repeated, though not very strong buy signals.
The RSI and MACD
Let’s take a look at the SPY for the period of large price movements between February and June 2020 and compare the signals generated the RSI with those of the MACD, which we examined here.
As the chart shows the SPY, which is just tracking the Standard and Poor’s 500 Index reached a peak around mid-February after a long and significant bull market over the previous 3 years. The market started to drop in early March and plunged to a bottom about 30 percent off its February peak around 23 March. The market climbed back from there and nearly reached the same price level as its earlier February peak during the first week of June.
Signals from the RSI
Over this period the RSI gave the following signals
- Sell signal around 20 January
- Buy signal around 1 March
- Sell signal around 12 June
Signals from the MACD
Over this same period, the MACD gave these signals
- Sell signal around 18 February
- Buy signal around 25 March
- Weak sell and buy signals around 9 and 18 May
- Sell signal around 13 June
For this ETF and during this period there is little doubt that the MACD gave more reliable and successful buy and sell signals than did the RSI.
Limitations of the RSI
I think we have seen that the RSI is actually quite limited. That should not be surprising as it is only a way of looking at price movements of a stock without reference to the market or other factors. It is just a price momentum tool and should only be used with that in mind. To find out more about the Relative Strength Index, check here.
A summary of the Relative Strength Index is available as a downloadable PDF here.
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