This is part 12 of a series on technical analysis; this section is specifically about momentum and relative strength. Click here for the series overview in part one. Click here for part two on the history of technical analysis. Click here for part three on an overview of candlestick charts. Click here for part four on basic candlestick patterns. Click here for part five on advanced candlestick patterns. Click here for part six on Bollinger Bands. Click here for part seven on trend lines. Click here for part eight on Fibonacci retracements. Click here for part nine on moving averages. Click here for part 10 on support levels. Click here for part 11 on resistance levels.
Another important concept in technical analysis is momentum. Because technical analysis focuses on trends and patterns, momentum plays a big role. Momentum is more than just a general downtrend or uptrend. It requires a simple calculation and results in several important indicators used by technical traders. Momentum is a measurement of the rise and fall in prices. It’s more useful during bull markets than it is during bear markets, so it’s a good thing that bull markets usually last longer than bear markets.
Calculating an asset’s price momentum
To find a security’s momentum, you subtract today’s closing price from the closing price a certain number of days ago. You can use any number of days, depending on your needs. For example, to calculate the momentum of an asset for the last 20 days, you subtract today’s closing price from the closing price 20 days ago. The result is a positive or negative number which is then plotted on a chart.
Technicians use momentum to show which direction an asset is trending in. When this calculation is positive, some traders use it as a buy signal, while a calculation under zero is sometimes seen as a sell signal because it shows downward momentum.
Momentum is a trend-following indicator, which basically just means that a sell signal is triggered when it peaks and begins to fall. A buy signal is triggered when momentum bottoms out and starts to rise.
The relative strength index
Perhaps the most important momentum indicator is the relative strength index, a value that ranges from zero to 100 as the price changes. J. Welles Wilder Jr. developed the relative strength index in the late 1970s, and it’s now considered one of the most important indicators in all of technical analysis.
Calculating the RSI is a two-step process. Most technical trading software will do these calculations for you, but here’s the framework for how it is calculated. The first step is to take 100 over 1 plus the average gain divided by the average loss. This value is then subtracted from 100 to complete the first step. The average gain and average loss are the average percentage gain or loss during the timeframe you select. The average loss is given in a positive value rather than negative.
Most technical traders use 14 days or other time periods to calculate the first value. After the RSI for each of the first 14 periods has been calculated, the second part of the formula can be completed. The second step smooths out the results. To get this step, you take 100 over one plus the previous average gain times 13 plus the current gain divided by the previous average loss times 13 plus the current loss. Then you subtract this total from 100. Computers have certainly made these calculations much easier to do.
The relative strength index of any asset is plotted on a chart, just like other technical analysis indicators. Generally, traders plot the RSI on the same chart as the price to compare the two. Most of the time, the RSI is calculated daily instead of hourly, buy some day traders may use shorter timeframes when trying to decide whether or not to buy an asset on a particular day.
Signals observed in the RSI
The most basic interpretation of the RSI Is that an asset is overbought when it surpasses 70 and oversold when it falls below 30. The RSI increases with a greater number of positive closes and declines as the number of negative closes increases. Traders tend to sell overbought securities, assuming that the price will fall eventually, and purchase oversold securities, assuming that the price will reverse.
Other than overbought and oversold levels, one other important note to make with the relative strength index is when it diverges from the security’s price. When the two diverge, it’s believed that the market is about to turn. A bearish divergence is marked when an asset’s price hits a new high while the RSI hits a lower high in overbought territory, which could signal a downward reversal. A bullish divergence is seen when the price hits a new low, but the RSI has reached a higher low and is in oversold territory. Some trades use a bullish divergence as a signal to buy an asset because it’s often a signal of early bullish momentum.
One other signal to watch for in the RSI is a bullish or bearish swing rejection. This signal is a bit more complex because it’s a series of four steps following each other. In the case of a bullish swing rejection, the first step is for the RSI to enter oversold territory. That step is followed by a cross back above 30, or an exit from oversold territory. Next is a decline that doesn’t take it back into oversold territory, followed by a break above its recent high.
The bearish swing rejection follows the exact opposite pattern. It starts with the RSI entering overbought territory and then falling back under 70. Next is another high in the RSI without re-entering overbought territory and then a break below its recent low.
The relative strength index differs from and is often confused with relative strength, another momentum indicator used in technical analysis. Relative strength simple compares the price performance of one stock, mutual fund or exchange-traded fund to the performance of the rest of the market, using a key benchmark to measure it. This enables investors to see which fund or stock is the best-performing compared to the rest of the market, thus making it a bit easier to screen selections. Relative strength assumes that the general trend will continue, so if the performance has been moving upward, a continuing upward trend is assumed. Of course, this isn’t always the case, so as with all technical indicators, relative strength should not be used on its own.
Relative strength can be calculated by simply selecting the best-performing stocks or by looking deeper and calculating the rate of change in the stock’s price over a set time period. This rate of change is then divided by the rate of change in a comparable benchmark or index over the same timeframe. When the calculation is more than one, it means the stock is strong, but if it’s less than one, then it means the stock or fund is weak versus the index it is being compared to. In the case of mutual funds, technical traders use the net asset value in place of the stock price. The fund’s net asset value is then compared to the net asset value of comparable mutual funds.