Tuesday, June 7, 2011

Relative Strength Index - RSI

The relative strength index, RSI, is one of the most popular price momentum indicators. RSI quantifies price momentum only and does not relate any security to another security. It depends solely on the changes in closing prices.

RSI is calculated using an exponential moving average which correctly avoids the problem of erratic movement. The time period used for calculating RSI varies. The most widely used is 14 days. Other popular lengths are 20, 10, 8, 7, and 5 days. Since RSI is a ratio, its range is limited from 0 to 100.

The Equis International MetaStock System Testing rules for RSI are:
Enter long: RSI<30
Close long: RSI>70

The chart above is the daily SPY stock chart. According to RSI levels, the green arrows indicate entering long positions. The red arrows indicate RSI levels to close the long positions. In this particular example, all three trades would have been profitable.

The chart above is the daily BAC stock chart. Here, you can see examples of the holes in the RSI indicator. There are six examples that indicate to take a long position but do not reach its target of an RSI above 70.

No indicator is perfect and its important to understand the pros and cons to all indicators.  For me I use RSI to sell longs into over bought areas and cover shorts into oversold areas.  This indicator works well in trending markets.  All the SPY trades worked because it was trending up... If you used RSI for BAC and recognized its been trending down you would have only took sell signals to start the trade and buy signals to cover.  Changes the PnL dramatically!

Trade 'em well.

No position at this time. Position declarations are believed to be accurate at time of writing but may change at any time and without notice.

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