The Relative Strength Index (RSI)
Don't be oversold on this or any other index.
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Developed by Welles Wilder in 1987, the Relative Strength Index (RSI) is an oscillator -- an index whose value oscillates between an upper limit and a lower limit, like a pendulum.
Wilder's basis for the index is the number of days in a given length of time that the market or a stock is up in price compared with the number of times it's down. This gives the relative strength of the traded item. (The measure doesn't consider trading volume.) The comparison is a ratio. Bauer and Dahlquist present it as the ratio of the total number of "ups" in n periods to the total number of "downs" in the n periods. That is:
RS = (ups/n)/(downs/n) = ups/downs
Presumably, the market has something like a true value at any given moment around which the price varies. Perhaps this is the moving average. Rather than stay at the true value, however, market forces carry the price too high, or drive it too low -- too high when expectation for lower prices reaches a peak, and too low when traders believe prices will rebound. The price is "stretched" too far, and, like a rubber band, will return to "normal." But in so saying, the value is defined in terms of what the traders do, rather than some intrinsic value of the stock. Maybe that's enough.
The RSI itself converts the possibly (indefinitely) large variations in price to a fixed range -- between 0 and 100:
RSI = 100 - (100/(1 + RS)
Since RS is in the denominator, high RS means high RSI. If the relative strength (RS) is very low, say down around zero, the amount subtracted from 100 is very high, so the value of RSI is very low, near its minimum of zero. But when RS is large, the amount subtracted from 100 is low, so RSI is near 100 -- the maximum. Large values in RSI would then signal a downturn in prices, whereas small values would signal an upturn. "Large" and "small" are understood to be readings of 70 or above and 30 or below, respectively.
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As a measure of money flow into or out of a security, this index relates to the Relative Strength Index. But it's different in that it uses volume as well as price. To get the money flow into or out of the equity, you have to multiply the price at which the equity trades by the number of shares traded. The Money Flow RSI draws on a comparison of the money going into an equity with the money coming out of the equity.
The key is to define precisely what it means to say money is moving into or out of a stock. This is done by establishing a typical price for the equity for a trading period (like a day), multiplying the price by the volume, differentiating between buying periods and selling periods, and summing the values over a specified length of trading periods. The results are then compared with the price of the equity.
To quote Bauer and Dahlquist:
This indicator looks for divergence between the indicator and the price action. If price is trending higher and the Money Flow Relative Strength Index is trending down, volume must be trending lower. This signals an imminent price reversal. Likewise, a lower price accompanied by a higher Money Flow Relative Strength Index indicates increased volume at the falling price; the price should begin to increase.
The "typical price" of a stock for a trading day (PTi) is understood to be the average of its daily high, low, and closing price and is therefore calculated as:
PTi = (high + low + close)/3,
the high, low, and close being rated equal in importance.
To get the money flow into or out of the equity for the given day, it's necessary to multiply the typical price by the day's volume for the stock. Money is then presumed to be flowing into the stock on that day if the typical price is greater than it was on the previous day (M+i). And money is presumed to be flowing out of the stock if the typical price is less than it was the previous day (M-i). In the first case the money flow is positive, and in the second case the money flow is negative. The formula for money flow for the day is therefore:
M+i = PTi*Volume, if PTi > PT(i-1)
or
M-i = PTi*Volume, if PTi < PT(i-1)
Money flow is negative if today's PTi is less than yesterday's, and it is positive if today's is greater than yesterday's. In the first case the sign is negative, and in the second it is positive. It is otherwise zero, of course.
Now, to calculate the Money Flow Relative Strength Index, you first have to choose a look-back period (n) and add the money flows for the period. That is:
M+T = åM+i
or
M-T = åM-j
The Money Flow Relative Strength Index for the day is then:
RSIMF = 100 - (100/(1 + M+T/ M-T)
Like the RSI, this oscillator ranges between 100 and 0. When money flow for the n trading periods is neutral, M+T equals M-T, so RSIMF equals 50. When money flow is large and positive, RSIMF is near 100, keeping in mind that both M+T and M-T can't be large simultaneously. And when money flow is large and negative, RSIMF is near zero.
So, you have to compute the total money flow every day to deal with the past n trading periods relative to the new day. Thus, whenever RSIMF drops below 50, money flow is negative, or money is now flowing out of the equity. And when RSIMF goes above 50, money flow is positive, or money is now flowing into the equity. The former condition is a sell signal, and the latter is a buy signal.
It's instructive to relate these ideas to rate of change.
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