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When talking about the strength of a stock or overall market, one great tool is the relative strength index (RSI) which is a comparison between the days a stock finishes up against the days it finishes down. It is a big tool in momentum trading. Depending on the type of investor, the RSI can be used to detect strength over a couple hours or over several months. Obviously, the longer trends are more valuable to long-term investors, whereas short-term trends in the RSI are popular with traders.
RSI = 100 - [100/(1 + RS)]
RS = (Avg. of n-day up closes)/(Avg. of n-day down closes)
n= days (most analysts use 9 - 15 day RSI)
The RSI ranges from 0 to 100. A stock is considered overbought around the 70 level - a reason to consider selling. This number is not written in stone, in a bull market 80 is a better level because stocks often trade at higher valuations. Likewise, if the RSI approaches 30, a stock is considered oversold - a cause consider buying it. Again, make the adjustment to 20 in a bear market.
A long-term RSI is more rolling and it fluctuates a lot less. Different sectors and industries have varying threshold levels when it comes to the RSI. Stocks of some industries will go as high as 75-80 before dropping back and others have a tough time breaking past 70. A good rule is to watch the RSI over the long term (one year or more) to determine at what level the RSI has traded in the past.
|This chart was supplied by Barchart.com|
Here we have an RSI chart for AT&T (T). The RSI is the green line and its scale is the numbers that go from 0 to 100. Notice that the RSI was approaching the 60-70 level and then the stock (blue line) sold off, both in December and January. Also notice around October when the RSI dropped to 25 the stock climbed up nearly 30% in just a couple of weeks.
Arms Index (TRIN)
The Arms Index is commonly referred to on financial television and short-term trading websites. Arms is a market performance indicator that varies from the A/D and RSI because instead of simply looking at the number of up and down ticks (or stocks) the Arms Index weighs each stock by the volume traded for each issue. A ratio of one means that the market is in balance. A ratio above one indicates that more volume is moving into declining stocks. A ratio below one indicates that more volume is moving into advancing stocks.
Both the RSI and Arms are great little indicators that can help you detect the overall strength of the market. Most investors agree that the RSI and Arms is most effective in "backing up" or increasing confidence before making an investment decision.
Next: Market Strength: Oil and Bonds »
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