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

How to invest in ChatGPT and other AI tech changing the world
Tech stocks

How to invest in ChatGPT and other AI tech changing the world

Technology, like ChatGPT, is changing the way we live and work, and this new tool could have a huge impact on the tech industry says Dominic Frisby.
23 Jan 2023
Active investing vs passive investing: which is best?
Investment strategy

Active investing vs passive investing: which is best?

Active investing strategies didn’t do well in 2023 as passive investing continued to draw in new assets.
20 Jan 2023
Key dates for 2023: here are the dates you need to know when it comes to your money
Personal finance

Key dates for 2023: here are the dates you need to know when it comes to your money

There is no shortage of important dates to be aware of this year – which are likely to affect your financial health. We run through the key dates in 2…
4 Jan 2023
Investing trends to watch out for in 2023: what analysts say
Investment strategy

Investing trends to watch out for in 2023: what analysts say

What are sensible strategies for high inflationary times? We ask analysts to find out.
22 Dec 2022

Most Popular

Top 10 areas most immune to a house price crash
House prices

Top 10 areas most immune to a house price crash

New research pinpoints the towns, cities and London boroughs most insulated from house price falls this year - and which are the most exposed.
31 Jan 2023
When will interest rates go up?
UK Economy

When will interest rates go up?

New interest rates will be announced on 2 February – we look at what to expect.
1 Feb 2023
Top 10 up and coming property areas in the UK
Property

Top 10 up and coming property areas in the UK

New research shows rural areas make for the best investment, while London boroughs dominated the bottom 10
31 Jan 2023