28 AAII Journal/May 2000

TECHNICAL ANALYSIS

In his 1978 book, “New Concepts in Technical Trading Systems,” J. WellesWilder (Trade Research) introduced the relative strength index (RSI). Thisindicator, which has gone on to become one of the most widely used techni-cal indicators, is a momentum indicator that belongs to a family of indica-tors called oscillators. An oscillator gets its name from the fact that it movesor oscillates between two fixed values based on the price movement of asecurity or index.

Wilder’s RSI should not be confused with relative strength figures thatappear in publications such as the Investor’s Business Daily and AAII’s StockInvestor program. Those relative strength calculations compare the pricemovement of a security or index against the price movement of some broadmarket measure such as the S&P 500. In other words, they show how well aparticular index or security has done relative to the broader market. Perhapsa better name for the Wilder RSI would be the internal strength index—theRSI compares the price relative to itself.

The RSI has been found to have the most favorable results when used inthe futures and commodities markets. Furthermore, the RSI is most used overa short trading period—both of which make the RSI best-suited for activetrading or short-term investors. However, it is also used with equities, mutualfunds, and indexes. The reason for its popularity lies in its versatility, mainlyin identifying market extremes and illustrating points of divergence that mayindicate an approaching reversal of the price trend. Furthermore, researchindicates that for shorter periods, RSIs are leading indicators, meaning thatthey signal price tops and bottoms before they actually occur.

This article focuses on two of the more popular uses of the RSIs—identify-ing market extremes and divergences.

CALCULATING RSI

Before you begin using the RSI in your trading, you need to decide on theperiod length you wish to use. When Wilder developed the relative strengthindex, he based it on 14 periods. A period can be a day, week, month, etc.;therefore, using a 14-period relative strength index would give you a 14-day,14-week, or 14-month calculation. While 14 periods is the default value formost technical analysis software programs and Web sites, nine- and 25-period relative strength indexes are also gaining in popularity.

The Wilder RSI is a ratio of the average points gained during “up” periodsover the past n periods divided by the average points lost during “down”periods over the same period. Most technical analysis software programs willperform this calculation for you. However, the formula is:

RS = Avg. price change on up days ÷ Avg. price change on down days

The RS value is then entered into this formula to give you the relativestrength index:

RSI = 100 – [100 ÷ (1 + RS)]

By Wayne A. Thorp

Wilder’s relativestrength indexmeasures a stock’sprice relative to itselfover time. Itspopularity lies in itsversatility inidentifying marketextremes andillustrating points ofdivergence that mayindicate anapproaching reversalof price trend.

Wayne A. Thorp is assistant financial analyst of AAII. The figures in this article wereproduced using MetaStock by Equis.

MEASURING INTERNAL STRENGTH:WILDER’S RSI INDICATOR

AAII Journal/May 2000 29

TECHNICAL ANALYSIS

The resulting value will range, oroscillate, between zero and 100. Asyou will see, the RSI spends most ofits time fluctuating between 30 and70, unless strong price movementsforce the RSI outside of this range.

In Figure 1, you cansee the 14-day RSIplotted for Walt DisneyCo. When looking atan RSI graph, youshould note severalitems. First of all,horizontal lines at the30 and 70 levelsindicate the predeter-mined oversold andoverbought levels. It isimportant to note thatthe vast majority of themovement is betweenthe 30 and 70 levels.The crossing of theselines indicates that asecurity or index maybe oversold or over-bought. Secondly, thereis the RSI line itself,which has experienceda wide range ofmovement over thisthree-year period.

TOPS AND BOTTOMS

Historically, levels above 70 havebeen considered overbought—wherecontinued buy interest is overex-

tended—and levelsbelow 30 are over-sold, where sellingpressure has reachedits maximum. Today,80–20 is becomingmore prevalent asregions of overboughtand oversold, espe-cially with the in-creased use of thenine-day RSI. Thenine-day RSI tends tobe more volatile ascompared to RSIs oflonger time periods.Furthermore, today’smarkets are morevolatile, which maycause the RSI toexhibit wider fluctua-tions.

For the sake ofcontinuity, this article

will use the 70–30 levels throughout.When the RSI crosses above 70, thepossibility of a reversal of theupward trend greatly increases.Likewise, when the RSI crosses

FIGURE 1. WALT DISNEY 14-DAY RSI

FIGURE 2. MICROSOFT: TRADING ON RSI CROSSOVER SIGNALS

30 AAII Journal/May 2000

TECHNICAL ANALYSIS

below 30, the possibility of thedowntrend reversing also increases.Be aware, however, that these levelsare by no means fixed. It may bebeneficial to view RSI behavior fora security or index over time togauge where the extremes exist. Indoing so, you will find that differentsecurities have varying overboughtand oversold levels. Furthermore,just because the RSI enters into theseextreme levels, it does not mean younecessarily need to buy or sell,depending on the RSI level. At aminimum, such movements shouldalert you to the possibility that atrend reversal is imminent.

There are several ways to tradethe RSI based on its movementabove 70 and below 30. First of all,you could buy when the RSI fallsbelow 30 or sell once it crossesabove 70. The main drawback tothis approach, however, is that youmay be entering into a trade beforethe trend has run its course. Often,the price will continue to rise evenafter the RSI crosses above 70,meaning you will miss out on someprofits. Furthermore, you may haveto carry a loss for an uncertain

amount of time if you buy when theRSI crosses below 30 and the pricecontinues to fall.

You could also sell when the RSIcrosses below 70 and buy when itcrosses above 30. This also happensto be a popular trading strategywhen using the nine-day RSI. Figure2 illustrates this approach forMicrosoft. From March 30, 1998, toMarch 28, 2000, this system gener-ated five round-trip trades. Thesefive trades returned a 106.5% profitover this two-year period. Be aware,however, that selling when the RSIcrosses below 70 and buying when itcrosses above 30 will have youentering trades once the uptrend hasalready begun and exiting after adowntrend has taken form.

Taking a more centrist approach,you can sell when you see the RSIbegin to turn downward above 70and buy when the RSI beginsbottoming out below 30. Dependingon the trading behavior of a particu-lar security, however, this strategymay also be less than optimal.During strong price trends, the RSItends to move to the extremes andthen may give off false signals that

could have youentering or exitingtrades prematurely(as we will seelater).

There may betimes, however,when there is notsufficient pricevolatility to movethe RSI into theseextreme ranges. Inthis case, you maywish to increase theamplitude (wideness)of the RSI byshortening the timeperiod to the extentthat the indexmoves above 70 orbelow 30. Shorten-ing the time periodincreases thesensitivity of theindicator to price

movements, thus increasing itsvolatility.

Likewise, in a market where thereis a lot of volatility, the RSI willtend to make numerous movesoutside of these boundaries. Suchactivity makes the signals that suchmovement generates less useful.Here it may be necessary tolengthen the time period. Lengthen-ing the time period slows reaction toprice changes, thereby making thesignals less frequent, and moremeaningful.

Figure 3 shows the daily priceplots for Netopia as well as two RSIplots—a nine-day and a 14-day.From this chart, you can see that thenine-day RSI is more volatile. Thereare several times when the 14-dayrelative strength index does notventure outside of the 70–30 bound-aries, while the nine-day does (thecircled areas on the chart). Using thenine-day RSI for Netopia, therefore,would yield more buy and sellsignals than would the 14-day. Byaltering the number of periods usedin the calculation, you may developa better sense of what works best,given your particular trading style.

FIGURE 3. NETOPIA PRICE CHART, NINE-DAY RSI & 14-DAY RSI

AAII Journal/May 2000 31

TECHNICAL ANALYSIS

DIVERGENCE

When you compare the pattern ofa price chart and the RSI, youwould expect that the two for themost part would move in the samedirection. There aretimes, however, whenthe RSI and price willmove in oppositedirections—in otherwords, the two valuesdiverge. Some of themost powerful signalsthe RSI will generateare when there is adivergence between theindicator and price.When this occurs, theprice eventually willreverse and again“follow” the RSI.

One way in whichdivergence takes placeis when the price hits anew high while the RSIis above 70. After apullback, the pricegoes to a new high.However, the RSI—while still above 70—

fails to rise above its prior peak.The creation of a double-top by theRSI (two peaks at roughly the samelevel) or a series of descendingpeaks while the price is reachingnew highs should serve as a warning

that negative diver-gence is taking place.

On the flip side,divergence takesplace when prices aremaking successivelylower lows as theRSI, which is below30, makes a double-top or a series ofhigher highs. Againthis should serve asan alert that pricesmay begin anupward track.

This is the case inFigure 4, whereNorthrop Grumman’sprice is in a steadydownward trendwhile its 14-day RSIis making a series ofhigher highs below30. After severalweeks of this diver-

gence, the price reverses in anupward direction.

Often when negative divergence isdeveloping, the confirming signalcomes in the form of a “failureswing.” After establishing two peaks

FIGURE 4. NORTHRUP GRUMMAN: TRADING ON RSI DIVERGENCE SIGNALS

FIGURE 5. AMGEN: FAILURE SWING SELL SIGNAL

32 AAII Journal/May 2000

TECHNICAL ANALYSIS

above 70 while the price continuesto rise, the RSI then falls below thetrough formed between these twopeaks. When this occurs, a potentialsell signal is given—irrespective ofthe fact that the price may still berising.

Such is the case in Figure 5. Herewe have the daily price plots forAmgen and a nine-day RSI. Fromthe chart, you can see that, over theperiod January 3, 2000, to January24, Amgen was in a steady uptrendwith three successive higher highs.However, during this same period,the RSI was showing ever lowerlows—a distinctive sign of negativedivergence. On January 10 and 21,the RSI formed a double-top near75. After forming the second peak ofthe double-top, the RSI began to falland continued down past the levelof the trough formed between thetwo peaks. This failure swing wouldindicate a signal to sell. Shortlythereafter, Amgen’s price began tofall, from a high of $76.50 onJanuary 24 to a low of $59.13 onJanuary 27.

At the bottom, circumstances arereversed. The RSI forms a double

bottom below 30, at which point theRSI goes above the previous peak—generating a buy signal.

LIMITATIONS

As is the case with all types oftechnical indicators, the RSI doeshave some limitations. Perhaps thegreatest handicap it has is that it isnot overly useful in trending mar-kets. In other words, its usefulnessbreaks down when prices are in asustained up- or downtrend. This isbecause, during persistent trends, theRSI moves to extreme levels andcan remain there for weeks or evenmonths, at which point it cannot belooked upon to generate useablesignals.

As an example, Figure 6 shows theprice and 14-day RSI for OrtelCorporation. On September 28,1999, the RSI signalled a buy as itrose above 30. For the next couple ofweeks, the RSI rose sharply while theprice was all but flat. In mid-October, Ortel began to rise, drivingthe RSI to a peak of almost 90.While the price continued to rise, theRSI fell below 70 on October 29—a

sell signal. For thenext five months theRSI drifted aroundthe 70 level—nevergenerating a buysignal. Meanwhile,Ortel’s price appre-ciated almost 480%after the sell signal.The most you couldtake away from theextreme rise in RSIis that the price wasprobably entering atrending period.

For this reason, theRSI should not beviewed in isolation.Using it in tandemwith other indicatorssuch as movingaverages may helpeliminate such falsesignals.

CONCLUSION

The Wilder RSI may be helpful inidentifying potential reversals in anexisting trend, assuming you are ina trading market and are a trader.While the signals it generates forsuch market behavior may behelpful, it is also clear that the RSIbreaks down during strong trends.

Like all technical indicators, theRSI is not intended to be the indica-tor. By using it in conjunction withother indicators, you may be able todevelop a system that functions inall types of markets. Web sites thatoffer the RSI in their chartingcapabilities include BigCharts(www.bigcharts.com) and MetaStockOnline (www.metastock.com).

This article has presented severalways in which you can use the RSIas part of a systematic tradingapproach, but it also serves as anintroductory base from which youcan begin to formulate your ownstrategies. Only through time, effort,and trial and error will you find asystem that best suits your needs. ✦✦✦✦✦

FIGURE 6. ORTEL CORP. PRICE & 14-DAY RSI IN SUSTAINED UPTRENDING MARKET