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

Expect more turbulence as the market calls central bankers’ bluff
Stockmarkets

Expect more turbulence as the market calls central bankers’ bluff

With bond yields climbing and stockmarkets sliding, markets are hoping central bankers will step in again to repress interest rates – but that won’t …
26 Feb 2021
The MoneyWeek Podcast: strategic metals, the commodities supercycle and the electrified future
Commodities

The MoneyWeek Podcast: strategic metals, the commodities supercycle and the electrified future

John Stepek talks to Dr Paul Jourdan, CEO of Amati Global Investors, about investing in the metals needed for the post-oil electrified world, the impo…
26 Feb 2021
Our trade of the decade came good – what’s next?
Investment strategy

Our trade of the decade came good – what’s next?

Back in 2010 we said you should invest in unloved and undervalued Japanese stocks. If you had done that, you’d have made a nice return. So what should…
25 Feb 2021
Great frauds in history: Helmut Kiener, Germany’s mini-Madoff
People

Great frauds in history: Helmut Kiener, Germany’s mini-Madoff

The performance of Helmut Kiener’s fund of funds, which invested money from institutions and private investors into hedge funds, seemed too good to be…
25 Feb 2021

Most Popular

The days when you could get 7% from your bank are long gone – so what do you do?
Bitcoin

The days when you could get 7% from your bank are long gone – so what do you do?

With interest rates at rock bottom for so long, we’ve been forced to move from saving to speculating to earn any sort of return. Dominic Frisby asks w…
24 Feb 2021
Why you should still put money into a cash Isa
Cash ISAs

Why you should still put money into a cash Isa

Interest rates may be lousy, but tax-free saving into a cash Isa is still a good idea.
23 Feb 2021
Are we heading for another bond market tantrum?
Government bonds

Are we heading for another bond market tantrum?

The last time the US central bank tried tightening the purse strings, the bond markets threw a tantrum. With yields now rising, could we be about to s…
25 Feb 2021