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

Three things you should learn from Bill Ackman's brilliant Netflix trade
Investment strategy

Three things you should learn from Bill Ackman's brilliant Netflix trade

Hedge fund guru Bill Ackman has lost $400m selling Netflix shares. John Stepek explains why this was a brilliant trade, and outlines three things that…
19 May 2022
The tech-stock bubble has burst – but I still want a Peloton
Stockmarkets

The tech-stock bubble has burst – but I still want a Peloton

Peloton was one of the big winners from the Covid tech boom. But it's fallen over 90% as the tech stock bubble bursts and and everything else falls in…
19 May 2022
Value is starting to emerge in the markets
Investment strategy

Value is starting to emerge in the markets

If you are looking for long-term value in the markets, some is beginning to emerge, says Merryn Somerset Webb. Indeed, you may soon be able to buy tra…
16 May 2022
James Anderson: innovation is still the key to returns
Investment strategy

James Anderson: innovation is still the key to returns

James Anderson, the man behind the Scottish Mortgage investment trust, tells Merryn Somerset Webb what he’d buy now
13 May 2022

Most Popular

Get set for another debt binge as real interest rates fall
UK Economy

Get set for another debt binge as real interest rates fall

Despite the fuss about rising interest rates, they’re falling in real terms. That will blow up a wild bubble, says Matthew Lynn.
15 May 2022
Is the oil market heading for a supply glut?
Oil

Is the oil market heading for a supply glut?

Many people assume that the high oil price is here to stay – and could well go higher. But we’ve been here before, says Max King. History suggests tha…
16 May 2022
Value is starting to emerge in the markets
Investment strategy

Value is starting to emerge in the markets

If you are looking for long-term value in the markets, some is beginning to emerge, says Merryn Somerset Webb. Indeed, you may soon be able to buy tra…
16 May 2022