J. Welles Wilder, Jr. is one of the most influential figures in modern technical analysis. He developed several popular technical indicators. Among the most popular is his RSI, or Relative Strength Index. Calculation of RSI is simple:
From price series of size , calculate the price change series of size s.t.:
From , calculate two series of size , (for gains) and (for losses) s.t.:
For and , we can calculate the Wilder’s Moving Averages, and . From and we can calculate Wilder’s Relative Strength Index (RSI):
RSI is thought to have many uses as an indicator. In particular, many investors believe that it can be used to indicate overbought and oversold levels. Common values of RSI used to indicate overbought and oversold levels are 0.7, for overbought indications–and 0.3, for oversold indications.
In a historical database of stock prices retrieved from Yahoo! Finance, from close to close, from the end of the day when RSI crossed the threshold, from below 0.7 to above 0.7 and above 0.3 to below 0.3, to close five days later, the geometric average returns were (0.135%) for crossing above 0.7 and 0.603% for crossing below 0.3. Using higher thresholds suggested even greater geometric average five day historical returns, (0.659%) and 1.765% for 0.8 and 0.2, respectively. While not every trade based on RSI makes money, clearly, it has been an incredibly powerful technical indicator.
(Note: When economists refer to Relative Strength, they usually mean the ratio of two price indexes.)