Assessing the historical performance and potential future growth of any business involves speaking in a range of abbreviated acronyms: DEER, PES, TTM, GARP and more. In addition to analyzing the company’s long-term track record and comparing it to similar companies, some investors prefer to take a closer look at each individual stock’s movement against its recent price movements to calculate another acronym: RSI. , or Relative Strength Index. .
What is RSI?
The Relative Strength Index (RSI) is an indicator of price momentum and its values range from 0 to 100. The number helps gauge whether the price of a stock is up or down. It takes into account both the frequency and the magnitude of price increases and decreases.
Although a lot has changed in investing due to technological disruption, RSI has been around since long before anyone could trade on their smartphone – or since anyone even had a smartphone. The concept of RSI first appeared in 1978 in J. Welles Wilder, Jr.’s book, “New Concepts in Technical Trading Systems”, with the purpose of helping to understand whether a stock was overbought or oversold. It is important to note that RSI is part of what is called technical analysis. This field looks at price momentum or other “technical” factors such as patterns in price movement charts to forecast future price movements.
These visuals may look complex, but they aim to answer a simple question: will it make or lose money?
The chart below details Amazon’s stock (top) from August 2020 to August 2021 and its relative strength (bottom) over the same period. The stock chart shows absolute performance in dollars, while the RSI chart measures the performance of the stock relative to its own price history, so it is calculated on a percentile basis, on a scale of 1 to 100.
What does it mean when a stock is overbought versus oversold?
An RSI in the upper range – especially above 70 – shows that a stock has experienced strong upward price momentum. However, this momentum can often indicate that the stock is overbought. Investors may be more inclined to sell to take advantage of the buying momentum and take some of their profits.
A lower RSI – especially in the range below 30 – tends to be associated with overselling. Downward price momentum is often seen as a reflection of the action being due for a rebound, meaning now is a good time to be on the winning side of the buy low and sell high game plan. .
How to Calculate RSI
You can use the RSI for any time frame, but the most commonly used window includes the last 14 days of market activity. Thus, you will add up all the winnings over the period and divide your average winnings by 14. Then you add up all the losses and divide by 14 to calculate your average losses. Now divide your average wins by your average losses. This is your relative strength (RS).
Then you enter that number into Wilder, Jr.’s formula for RSI: (100 – 100/(1 + RS)).
The RSI isn’t just for individual stocks either. The figure can apply to entire markets. For example, analysts will calculate the RSI of the S&P500 and other indices to get a picture of trending activity across the stock market as a whole.
RSI versus MACD
RSI shares some similarities with MACD, which stands for Moving Average Convergence/Divergence.
The MACD is another technical indicator of price momentum that looks at moving averages over certain time frames and whether they join – converge – or move apart – diverge. This tool is often used in conjunction with RSI to give traders more data to understand what the future holds for a stock or an entire market.
Advantages and disadvantages of using RSI
Here are some pros and cons of using RSI.
Advantages
- You can get a potential short-term benefit: RSI helps in taking an accurate snapshot of a specific period, which can offer valuable predictive information for immediate buy and sell decisions.
- The formula is relatively simple: RSI offers a basic mathematical look at the recent trend movement of any stock. The digit-centric approach offers a quantitative picture that does not involve deciphering signals from subjective inputs.
The inconvenients
- These subjective inputs are important: Qualitative factors such as the announcement that a new senior executive has been hired play a critical role in a stock’s performance. There is no place in the ROI formula to assess a new manager’s credentials.
- The formula is not designed for the long term: If you focus on the bigger picture — save for retirement, for example – the traditional 14-day RSI window is not the right solution. Instead, you’re better off using fundamental analysis that considers overall business, profitability, valuation, and more to forecast long-term returns.
- The formula may seem simple, but using it is not: Calculating RSI is simple, but buying and selling decisions are always complicated. The RSI is one of many indicators used by advanced level traders – not amateur retail investors.
