Any investor planning to buy or sell an equity can benefit from an analysis of its relative strength index, or RSI, a momentum indicator developed by technical analyst Welles Wilder in the 1970s. The RSI helps you determine if an equity should be bought or sold. While the RSI calculation is straightforward, the implications of the index are subtle and far-reaching. Under certain conditions, the RSI may give results that can be misinterpreted.
The Relative Strength Index Calculation
The RSI formula is as follows: 100-(100/1+RS), where RS equals average daily gain minus average daily loss over a set number of days, often 14. If, for example, the average gain on seven up days is $5 and the average loss on seven down days is $1, RS equals 4. Plugging the RS of 4 back into the formula gives an RSI of 80.
What the RSI Indicates
The RSI is a momentum indicator: It tells you how much and how quickly a stock is rising or falling in value and its likelihood of rising or falling in the immediate future. Technical analysts consider an RSI of 70 or more a possible indication that a stock is overbought -- that investors may have driven the price upward until it no longer represents good value and may be about to decline in value. An RSI of 30 or less indicates the opposite -- that the stock is oversold and may be about to rebound.
Using RSI to Establish Resistance Levels
You can also use the RSI to establish a probable resistance level -- the level at which a falling stock price may no longer fall or a rising stock price may no longer rise. Technical analysts consider an RSI of 50 a likely resistance point. When a stock breaks through a resistance level, analysts consider it more likely that a stock will continue to rise in the same direction. If a stock changes direction at the resistance level, analysts consider that the stock may now continue rising or falling in this new direction.
A Word of Caution
An influential 2000 article in "The Journal of Finance" by economists Brad M. Barber and Terrance Odean noted that the investment returns of active stock traders averaged about half that of longterm investors. They also found that the more often traders bought and sold stock, the worse their return on investment. Other studies have since confirmed this. This doesn't mean that technical indicators like the RSI are useless. The more information you have about a stock, the better, but you have to be careful about how you use it. For example, a longterm investor may use the RSI to identify an overheated market, then delay further stock purchases until it cools. If you do want to trade, keep in mind that RSI and other technical analytical tools are indicators of probability, not a guarantee of a particular result. Look at several different technical indicators to see whether they confirm or qualify the indication from the RSI.