RSI and Armageddon

Posted by barkand on February 6, 2011 under Uncategorized, Volatility | Be the First to Comment

While the S&P500($SPX) continues its almost daily march to new highs, RSI is giving us a stern warning of things to come. RSI had been making a series of higher highs from the beginning of December 2010 through the middle of January 2011. But since then the indicator has been making a series of lower highs. This divergence is considered by many to be a signal that the current trend is coming to an end, and is likely to reverse.

But what is the Relative Strength Index anyway? It isn’t relative strength. Let’s take a look at the formula.

RSI = 100 – (100/(1 + RS))

A high value of RS gives us a high value of RSI. And a lower value of RS then generates a low value of RSI. So what is this “RS”, then?

RS = (total “up” points / n) / (total “down” points / n)   —-  typically n = 14

So RS is a way of measuring volatility in the market. Let’s consider two scenarios, where the net point gain in each is 15 (which happens to be the case with SPX over the past 14 days).

Scenario 1:   20 up points, 5 down points —->  RS = 4 and RSI = 80

Scenario 2:   50 up points, 35 down points —->  RS = 1.428 and RSI = 58.8

The first scenario can be described as a quiet drift higher and produces a high value for RSI – some would call it “overbought”. In the second scenario there is perhaps more confusion. Or it could be that there is relatively high interest in the market and some are using the opportunity to exit. This is why low values of RSI are considered so dangerous when the market is making new highs. It is also a good example of why it is important to consider other information, rather than make decisions based on one indicator.