CHAPTER 6
FIN555
Introduction to
Technical Analysis
MOMENTUM II (RSI)
6.0 The Formula of RSI
6.1 Constructing Overbought/Oversold Lines
6.2 Time Span
6.3 RSI Interpretation
6.4 Price Oscillator
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6.0 The Formula of RSI
Let’s start our first set of slides
The Formula of RSI
The formula for the
The relative strength RSI is as follows:
indicator (RSI) was
developed by Wells Wilder.
The
Formula
It is a momentum indicator, or
oscillator, that measures the relative Where RS = the average
internal strength of a stock or market of x days’ up closes
against itself, instead of comparing one divided by the average of
asset with another, or a stock with a x days down closes.
market.
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The Formula of RSI
The The RSI formula not only
The default time span
recommended by Wilder is Formula provides this smoothing
characteristic, but also
14 days, which he justified results in an indicator that
on the basis that it was half fluctuates in a constant
of the 28-day lunar cycle. range between 0 and l00.
The indicator’s design aims to
overcome two problems involved in
construction of a momentum indicator:
(1) the need for a
constant trading band for (2) erratic movements
comparison purposes.
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The RSI Is Useful for Making
Comparisons Between Securities
The nature of the RSI
calculation allows the
accurate comparison of
different securities on the
same chart. In Chart 14.1
there are two series.
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Constructing
6.1 Overbought/Oversold
Lines
Let’s start our second set of slides
Constructing Overbought/
Oversold Lines
Because of this, it is much easier to establish universal standards for the overbought and
oversold benchmarks.
Using the 14-day default, they are traditionally set at 30 for oversold and 70 for
overbought.
In an article entitled “How RSI Behaves,” Peter W. Aan argued that the average value
of an RSI top and bottom occurred close to the 72 and 32 levels, respectively.
This research would indicate that the 70 and 30 levels recommended by Wilder should
be moved further apart to better reflect the average overbought and oversold value.
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Constructing Overbought/
Oversold Lines
Chart 14.2, for example,
features a 9-day RSI for the
Hang Seng Index in Hong
Kong, where an 80/20
combination gives a much
better feel for the
overbought/oversold extreme
than the 70/30 default value.
This is due to the fact that
shorter time spans result in
wider RSI oscillations.
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Constructing Overbought/
Oversold Lines
The lower panel features a
65-day RSI where the
narrower swings result in a
more appropriate 62.5/37.5
combination.
In this instance, neither of the
default 70/30 values is
reached at any time.
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6.2 Time Span
Let’s start our third set of slides
Time Spans
The RSI can be plotted for any time span.
If you make the assumption that the primary trend of the stock market revolves around
the 4-year business cycle, a moving average of 24 months will give you the greatest
divergence between the high and low points of the cycle.
In the case of the 28-day cycle, 14 days is the correct choice, but it is important to
understand that there are many other cycles.
Working on this assumption, for example, would mean that a 14-hour RSI would be
inappropriate if the dominant cycle was something other than 28 hours. The same
would be true for weekly and monthly data.
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6.3 RSI Interpretation
Let’s start our fourth set of slides
RSI Interpretation
Some of the principal
methods used to interpret the
RSI are as follows.
Extreme Readings and Failure
Swings Any time an RSI
moves above its overbought
or below its oversold zone, it
indicates the security in
question is ripe for a turn.
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RSI Interpretation
The significance depends upon
the time. For example, the 45-
hour RSI shown in Chart 14.7 is
nowhere near as significant as an
RSI constructed with a 12-month
time span, as in Chart 14.4.
An overbought or oversold reading
merely indicates that, in terms of
probabilities, a counterreaction is
overdone or overdue
It presents an opportunity to
consider liquidation or acquisition,
but not an actual buy or sell signal
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RSI Interpretation
More often than not, the RSI traces
out a divergence, as in Figure14.1.
In this case, the second crossover
of the extreme level at points A
and B usually offers good buy and
sell alerts.
These divergences are often
called failure swings.
A bearish failure swing can be
seen at the end of 2011 at point A
in Chart14.5 featuring a smoothed
version of a 9-day RSI.
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6.4 Price Oscillator
Let’s start our fifth set of slides
Trendline Violations and
Pattern Completions
The RSI can also be used in
1
conjunction with trendline violations.
Generally speaking, the longer the time span for
2 any particular period, i.e., daily, weekly, or monthly,
the better the opportunity for trendline construction.
Important buy and sell signals are generated when trendlines
for both price and the RSI are violated within the equilibrium
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line at 50, it’s apparent that the strong late June breakout
develops slightly above this critical point of balance.
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Smoothing the RSI
It is a perfectly legitimate
technique to smooth the RSI.
One of my favorite approaches is
to smooth a 9-day RSI with an 8-
day moving average (MA).
Because the fluctuations are not
as great as the raw data, the
overbought/oversold lines are
drawn at 70 and 30, not my usual
default of 80/20 for a 9-day span.
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Smoothing the RSI
Chart 14.5, featuring Molex,
contains a 9-day RSI smoothed
with an 8-day MA. The
downward-pointing arrows flag
all of the overbought reversals.
The solid ones show confirmed
reversals with varying degrees of
success. The dashed arrows
indicate overbought reversals
where it was not possible to
construct a meaningful trendline.
Needless to say, they were all
failures.
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RSI and Peak-and-Trough
Progression
The RSI often traces out a series
of rising or falling peaks and
troughs, which, when reversed,
offer important buy or sell alerts.
Chart 14.8 shows that the 14-day
RSI for Sun trust Banks
experienced two peak and trough
reversals, each of which was
confirmed by a price trend break.
These are flagged by the arrows.
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THANKS!
Any questions?
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