Tip # 3 – Analyze Your RSI Chart
Technical analyst J. Welles Wilder created the Relative Strength Index (RSI) as a tool to measure the strength or weakness of the closing price series of a security over time. It is a measure of both velocity (speed!) and magnitude (distance travelled) of price changes and can identify stocks that are either overbought or oversold.
The Relative Strength Index is calculated as RSI = 100 – 100/(1+RS). RS (Relative Strength) is usually calculated as the exponential moving average of daily gains/exponential moving average of daily losses during a defined time period. The standard time frame is 14 days. If losses over that time frame are close to 0, then RS approaches infinity, and the RSI approaches a 100 reading (moonshot!).
If you don’t follow the maths, don’t worry. What you need to know is that when the RSI is exceeding 70 or below 30, then the security in question is entering “overbought” or “oversold” conditions, meaning the price has moved very fast and covered a lot of ground in a certain direction, and may be due a breather. Hence, the RSI is a momentum indicator (oscillator) that we use to help us identify turning points in price action.
For the purposes of pair trading, we look at the RSI of the Price Ratio of security A/security B as opposed to the price action of an individual security. It is a closing price series over time and hence the RSI can be applied.
Pay Attention to the Foot on the Gas Pedal:
