The Holy Grail of Technical Indicators

The relative strength indicator is one of the most commonly used technical analysis tools available. Unfortunately it is also one of the most misused.

The RSI was a tool developed by famed market technician Welles Wilder during the 1970's as a way to determine whether a market was overbought or oversold. The formula is rather simple with the average number of up closing days divided by the average number of down closing days. So this indicator essentially measures the size of a stock's closing gains and compares it with the size of a stock's closing losses.

According to Larry Connors over at TradingMarkets.com who back tested this indicator from 1995-2006 in over seven millions trades there is no statistically significant edge using a 14 period RSI, which is generally the default setting for this indicator. However when used on a 2 period setting he found that it becomes a very effective tool in one's technical analysis arsenal.

Using the 2 period RSI we define overbought as a reading over 90 and oversold as any reading below 10. What Connors found was that a stock with a reading of 90 underperformed the benchmark index one week later, and a stock with a reading of 10 outperformed the index by an average of .50%. Furthermore he found that as readings became more overbought or oversold the amount that a stock moved was more substantial. For example if a stock had an RSI reading of 1 or below then within a week the stock averaged a 1% gain over the benchmark index, and if a stock had a reading of 99 or more the stock averaged a loss of -.31% compared to the index.

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