Stocks & Commodities V.

7:8 (243-245): Relative Strength Index by Peter Aan

Relative Strength Index

by Peter Aan

General Description: Originally designed as a chart trading tool to identify tops and bottoms soon after
they are formed; not mechanical; not always in the market.
Originator: J. Welles Wilder Jr.

ules and Formulas: The formula for computing the Relative Strength Index (RSI) is well-known

and computerized by dozens of commercial software packages.

Briefly, to compute a 14-day RSI, you must first collect 14 days of closing prices. Looking at the daily
net changes (DNC) from the previous close, add all of the up DNCs and divide by 14 to get the up
average. Total the down DNCs and divide by 14 to get the down average.
Divide the average up DNC by the average down DNC. Add 1 to this result and divide the new result into
100. Subtract this figure from 100 to get the first RSI:

100

RSI = 100 -
up average

1 + down
average

For each day thereafter, Wilder smooths the RSI with a pseudo moving average. The previous up average
is multiplied by 13, added to the current up close (if there is one) and divided by 14. Apply the same
steps to the previous down average and then plug the new up and down averages into the RSI equation.
Wilder considers RSI a charting tool, not a mechanical trading system, per se. When plotted below a bar

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Stocks & Commodities V. 7:8 (243-245): Relative Strength Index by Peter Aan

chart, the trader watches for divergence between price action and the RSI (Figure 1). A bottom
divergence, for instance, occurs when the actual price action exceeds a previous low, and the RSI fails to
penetrate its own previous low. The trader would not take action until the RSI then penetrates the interim
high between the two observed lows. This may be the best use of RSI, but subjective interpretation of
divergences presents major problems trying to mechanize RSI into a trading system that can be
computerized and tested over historical data.
Many traders use RSI as an overbought/oversold indicator (Figure 2) and that methodology is easily
tested on the computer. When using any overbought/oversold indicator, the trader typically is taking a
counter-trend position. An overbought condition indicates a top is soon to occur because the market has
risen to such a degree that it is overextended to the upside. This calls for a short position to take
advantage of the falling prices that will ensue once the market tops.
Testing: For this study, I tested RSI lengths of 9, 14 and 19 days in three ways:
The change of direction method requires (for a short signal) that the RSI trade into overbought territory
(above 70, for instance), then turn down for just one day.
The short is initiated on the next day's opening with an n-day high/low channel trailing stop. In other
words, once a short is initiated, a stop at the highest high of the most recent n days trails behind the
market to limit losses and protect profits. This seems prudent when using the RSI in this manner because
the losses could be substantial if the market trends strongly in one direction for an extended period of
time.
The "back-through" parameter method forces the RSI to trade above the overbought parameter (70, for
instance) and penetrate 70 from above signaling a sell on tomorrow's opening. Again, an n-day high/low
channel trailing stop is used.
The buy strength/sell weakness method takes a completely different approach. It buys when the market
reaches an overbought indication and sells on an oversold indication. The RSI then signals the start of
new trends. No stops are used in this method, and you are constantly in the market.
Comments: Veteran traders, including myself, usually will warn you that attempting to sell the tops and
buy the bottoms is, at best, a perilous exercise. It goes against that old market axiom: "The trend is your
friend."
It is interesting to note that many of the commodities showed only negative results when tested with the
two counter-trend methods. Even the optimal set of parameters showed negative results. Only Standard &
Poor's 500-stock index achieved its best results with one of these strategies, the change in direction
method and a 15-day high/low channel trailing stop (Figure 3)
One well-known trading advisor once said that "overbought markets should be bought not sold." This
study seems to be confirm this. Apparently, when a market exhibits enough of a thrust to achieve an
overbought/oversold reading it is often a sign that the market intends to trend further. Perhaps another
variation of RSI or the combination of another system or method would yield better results as an
overbought/oversold indicator, but I must conclude at this point that the RSI identifies trends better than
overbought/oversold conditions.
Peter Aan holds a master's degree from North Texas State University. He has been involved in the
commodity markets for more than a decade, spending much of that time in analysis and research. He

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Stocks & Commodities V. 7:8 (243-245): Relative Strength Index by Peter Aan

operates PWA Futures and is a registered broker with Dillon Gage, a Dallas-based brokerage.

Reference
Wilder, J. Welles Jr. [1978], "New Concepts in Technical Trading Systems," Trend Research:
Greensboro, NC 27402.

FIGURE 1:

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Stocks & Commodities V. 7:8 (243-245): Relative Strength Index by Peter Aan

FIGURE 2:

FIGURE 3:

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