The 'relative strength indicator': A useful tool for timing trades

Knowing when to buy or sell an asset can be as important as knowing how cheap or expensive it is. Here, Tim Bennett explains the momentum indicator that tells you when to trade.

Updated October 2019

At MoneyWeek, we are big fans of value investing buying stocks, sectors or even entire markets when they are cheap, as indicated by key ratios such as price/earnings (p/e) or dividend yield. But when it comes to timing a decision to buy or sell, momentum' indicators can also be useful. One such popular measure, highlighted by Big Picture blogger Barry Ritholtz, is the relative strength indicator (RSI).

What is the RSI?

The RSI calculation is fiddly, but you don't need to do it yourself any good charting package will do it for you. However, it is worth understanding how it is put together, so that you know what you're using. The basic calculation is: 100 (100/(1+RS)). RS represents the average gain over a selected number of trading periods, divided by the average loss over those periods.

Here's a simplified example. Let's say that over a given period the FTSE 100 gains an average of 50 points per winning session, and loses an average of 20 points per losing session. The RSI is 100 (100/(1+50/20)), which is 71.

The closer to 100 the reading is, the more overbought the index is. The closer to 0, the more oversold. Measured over a number of sessions (to smooth out the data), an RSI over 70 puts you in overbought territory and a reading below 30 is oversold, according to J Welles Wilder, who came up with the measure in the 1970s.

As with all measures, there are some pitfalls to be aware of. One is the number of trading periods used to measure average gains and losses Wilder recommended at least 14. As a rule, the more sessions you use, the greater the smoothing effect and the less likely the RSI is to hit overbought and oversold levels.

So, the more volatile the share or index, the further you should extend the calculation, to avoid constant buy' and sell' signals that could have you wipe out most of your trading gains in trading costs.

Recommended

Richard Marwood: dividends are back on the menu as earnings recover
Income investing

Richard Marwood: dividends are back on the menu as earnings recover

Merryn talks to Richard Marwood of Royal London Asset Management about which companies are recovering from the pandemic as people start spending again…
14 May 2021
Why investors should start to think more short-term
Investment strategy

Why investors should start to think more short-term

For years, investors have poured money into growth stocks that promise future profits but no actual cash now. But as inflation threatens, now might be…
13 May 2021
Should we adjust our all-weather ETF portfolio for inflation?
ETFs

Should we adjust our all-weather ETF portfolio for inflation?

It’s too early to batten down the hatches for our ETF model portfolio, but price pressures are increasing.
12 May 2021
Why ESG investing is becoming the norm
ESG investing

Why ESG investing is becoming the norm

A lot of investors say they want to put their money into “ESG” funds. But unless you actively opt for a “sin” fund jammed full of companies behaving b…
10 May 2021

Most Popular

How will Joe Biden’s capital gains tax rise affect crypto prices?
Bitcoin & crypto

How will Joe Biden’s capital gains tax rise affect crypto prices?

The US president wants to increase capital gains tax – and that’s going to hit a lot of American cryptocurrency speculators. Saloni Sardana looks at h…
14 May 2021
Are we nearing the end of the negative bond yield era?
Government bonds

Are we nearing the end of the negative bond yield era?

As inflation gets going, the era of the negative bond yield – that investors have to pay governments for the privilege of lending them money – might b…
14 May 2021
Inheritance tax planning: the rules around gifting
Inheritance tax

Inheritance tax planning: the rules around gifting

There are plenty of legal ways to minimise an inheritance tax bill. Perhaps the simplest is to give away assets to reduce the size of your estate. Dav…
11 May 2021