Relative Strength Index
Here we have a prevalent indicator called Relative Strength Index, or Wilders RSI. Developed by J Welles Wilder, this indicator measures the strength of any stock by dividing its average net up closing day prices by its average net down closing process for the period set.
RSI fluctuates between O and 100, 0 is oversold, and 100 being overbought. It is a leading indicator and can be used to predict future trend changes using positive or negative divergences compared to price.
Divergences are one of the most powerful ways to use most indicators. The fact that it is a leading indicator, as opposed to moving averages, which are lagging, and can thus indicate future directional changes.
The chart below is of Smith & Wesson (SWHC) and shows clearly how RSI can be used to help predict future trend changes.
Using RSI on two settings shows how shorter and longer-term settings can show a different line, but the same answer, therefore confirming each other.
- The shorter-term setting (7 Periods of Prices:7 Periods Smoothing)
- The longer-term setting (14 Periods of Prices:7 Periods Smoothing)
Review the chart and read below the five key points explaining usage.
Notes on the chart
- Here you can see the price highs trending downward from the period November 2008 to February 2009
- Here we see the price lows trending higher for the same period.
- So we see the forming of a price pennant, but which way will the stock price go? Up or Down. For the answer, we refer to the leading indicator RSI
- The RSI (7:7) orange line tells us as early as the beginning of January 2009 that we see stronger upward momentum in RSI, although this is not reflected in the price it is in the underlying action.
- The RSI (14:7) also confirms the shorter timeframe RSI settings but gives us a smoother line, which can be easier to interpret. Finally, in mid-February, the stock price bursts through the price high trend Line (point 1 above), and the stock proceeds to double in price (100%) in 5 weeks.
What a great result and what proof that RSI has real meaning and application. However, if RSI is telling you nothing important, then please use other indicators, or move on to review another stock where the indicators will tell you something.