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The relative strength index: a strength to put into perspective!

The purpose of this article is to take a step back on one of the most frequently used oscillatory indicators in technical and graphical analysis of stock market assets: the relative strength index, more commonly recognizable by its acronym RSI (relative strenght index), conceptualized, developed and popularized by J Welles Wilder Jr in the late 1970s.

What is it?

In the same way as the stochastic indicator, among other examples, the RSI indicator is a technical analysis tool of oscillatory type, namely that it forms over time “oscillations”, navigating in the direction of a high bound, then in the direction of a low bound, alternately.

It is therefore a curve, which is read in parallel with the prices (see the graphical example below). This curve is the graphical translation of a function of the price dynamics. The formula is as follows:

RSI parameter P=100-(100/(1+M)), with M= average of closing up / average closing down, over the last P sessions.

Thus, the RSI oscillates between 0 and 100, extremums that it never actually touches. It can tend quickly in case of bullish acceleration (100) or bearish acceleration (0) brutal.

The indicator must be configured: we traditionally find 14 days by default, on technical analysis software, but we can set it as you wish, to 07, or 21 days for example.

Finally, it is enough to define a high terminal triggering the overbought entry alert (70 or 80, for example) and a low terminal triggering the oversold entry alert (20 or 30 for example). The values 30 and 70 are usual for an RSI of parameter P=14, which we will use later and for that we will call RSI(14) for convenience.

A picture worth a thousand words…

Here is the graph of Saint Gobain shares, in daily candles, presented with trading volumes and RSI(14):

Passage of the RSI14 in overbought zone (>70), on Wednesday, January 12, 2022 on the Saint Gobain share, followed by a decline in prices. Source: Prorealtime -IT Finance.

Some ideas for interpretation:

When the RSI enters overbought territory, it indicates to the investor that the asset is finding it increasingly difficult to register regularly, and in a sufficient proportion, new highs: the buying movement is running out of steam. And a sell signal can come in when the RSI goes back below the alert line. Conversely, when the RSI enters oversold territory, it indicates to the investor that the release movement begins a gradual phase of deceleration, suggesting that selling pressure decreases.

The indicator is not read in absolute terms, but in its dynamics. How does it enter the overbought zone? How does it come out? Is there a discrepancy between its dynamics and those of the courses? How does it react to the vicinity of the neutral zone (50)? What is its speed, or even its acceleration from one terminal to another, to measure momentum variations, etc… So many questions to ask yourself when looking at the RSI curve.

Why “relativize” it?

Already because it does not constitute a martingale, like no other stock market indicator of the rest!

Secondly, because it can send a plethora of false signals, which encourage the investor too focused on the RSI to exit a position too early, while the full uptrend is installed.

It should not be analyzed alone, but in addition to an overview of other indicators and especially transaction volumes, which also make sense when it comes to talking about a “breathlessness” of movement, and accompaniment, by the level of participation, of momentum.

Finally, to properly dissect the mechanics of the indicator, it only translates, in another form, the appearance of the quotations. In the sense that the formula only “cooks” a single ingredient, namely the last closing prices. In a sense, a trained analyst’s eye is able, by looking at a stock chart, to immediately imagine the shape of the corresponding RSI curve… Ultimately, the slowdown and momentum movements are “seen” directly on the charts in closing data.

So the RSI would be useless?

To be thrown into oblivion?

However, and if it is not used as a magic formula – beware danger! -, the IHR can find its place judiciously in a technical study.

In the event of a bearish idea on the market, for example, and for the purpose of rapid and automated sorting of stocks on which to take profits, an RSI “filter” applied to all the stocks in a portfolio, makes it possible to visualize those for which the shortness of the buying camp is earlier, or stronger than for the rest of the market.

The amplifying effect of the decline in the market index on these stocks identified upstream will then be stronger. The goal is to determine which stocks have the greatest probability of falling sharper and faster than the rest of the market.

Alexandre TIXIER for Fibee

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