Technical Analysis, Using the Relative Strength Index

The Relative Strength Index (RSI) was developed by J. Welles Wilder. He first spoke about his system in a book called New Concepts in Technical Systems which was released all the way back in 1978. Apparently he was a nerd.

What the RSI does is it compares the magnitude of a stock’s recent gains to the magnitude of its recent losses. From there a number is derived between 0 – 100 to distinguish that comparison. For a 14-period RSI for example, the Average Gain equals the sum total of all gains divided by 14. It doesn’t matter if there were only 8 gains during those 14 trading days, the number is still 14. The Average Loss is found in a similar manor.

How to Use RSI

Instead of going into all the math equations and such to show the RSI, I found it 10x easier to learn just by looking at it and observing. There are a few things you need to know:

  • Overbought – A stock is overbought if the RSI shows a level above 70.
  • Oversold – A stock is oversold if the RSI shows a level below 30.

The centerline for RSI is 50. Understanding the main concept is very simple. If the stock is showing an RSI less than 50 we can say that the average losses are greater than the average gains, and with RSI above 50 we can say that the average gains are greater than the average losses.

Visual Example

Relative Strength Index Stock (RSI) Example

So, when looking at this chart of Dell Computers (DELL) we can see how the stock had a nice move up above $54 alongside the RSI moving up above 70. The stock then created a negative divergence as you can see in the blue over the next few weeks. This is bearish overall, and you can see how the stock then lost its momentum and sold off back in the the lower $50 and eventually in the high $40s.

Closing Notes

The RSI is a great technical indicator to utilize once you get the hang of it. It can help you make short term decisions for you portfolio, and heck can also make you some money. To learn more about technical analysis see the posts below and subscribe to the feed.

Further Reading:

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