This Week's Guidepost

RSI: Wilder's Relative Strength Index

This momentum oscillator is an overbought/oversold indicator we use to predict price reversals. The basis of its calculation lies in a period where the Up and Down closings are averaged. It is calculated thus:

The equation has the number 100 minus the bracketed term. If RS were zero, we would have 100 minus 100 and the RSI would be zero. The RSI could not be lower than this, or, zero represents its lower limit. If RS were very large, in which case the bracketed term were very small, the upper limit would be approached which is 100. We can see how the RSI cycles between zero and 100.

The bracketed term changes with RS, which is shown to be the ratio of two averages. Once the period or time span for the RSI is determined, we look at the number of days that were higher than the previous day during that period, and average their closing prices. That term is in the numerator. We do the same thing for the number of days that were lower than the previous day during that period. The average of these closing prices are placed in the denominator. This ratio is then RS. Now consider what this says. If the upticks are larger than the downticks during the period, RS will be larger making RSI larger, imply positive momentum. As the momentum slows, and the average downticks begin to exceed the average upticks, we near an overbought condition and look for the price action to follow down.

So, the RSI measures the relative difference between average upticks and average downticks. This is one focal angle.

Stochastics:

We covered this early in the series on technical analysis and have a tutorial on the page. This indicator operates on the theory that as prices increase, the closing prices tend to be more near the high for the session. On the other hand, as prices decrease, the close tends to be more near the session low. The stochastic is calculated for some time span, some number of sessions, in the relationship shown below.

If the close is near the low for the session, the numerator (C-L) will be low as well as the stochastics %K. As the close nears the high, (C-L) will be close to (H-L) and the stochastics will near 100%. We see again how this indicator cycles between 0 and 100%. N is the number of sessions used in the calculation and the %D is a 3 day moving average of %K. This provides the two curves used for the stochastics, with possible buy and sell points occurring where the two lines cross.

The Stochastics indicator measures the location of the closing price relative to the span between the high and low. Another focal angle, quite independent of the RSI.

On Balance Volume (OBV):

This momentum indicator is not an oscillator in the strict sense of the two previous examples. However, it does tell us a great deal about what the market sentiment is regarding a particular ticker. The OBV is a running cumulative total of positive and negative volume numbers. When a stock closes up, the volume that day is considered positive. Likewise, on a down day the volume is considered negative. The OBV line accumulates daily, increasing on positive days and vice versa. There seems to be no consensus on how far back the OBV should be calculated. History is not of much value here. What is important is the direction the OBV line is taking, not how high or low it is.

Often a price pattern just moves sideways, usually a period of indecision. However, this pattern can also be the start of a reversal. The OBV line can help us determine what the underlying character of the market is.

The OBV line provides yet another focal angle on the nature of the market. It does this by comparing the volume on up days to the volume when the price drops.

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