Flexible Relativity
The Self-Adjusting RSI
by David Sepiashvili
Here's how you can design self-adjusting overbought-oversold benchmarks for the relative strength index so it can be applied to multiple market conditions.
Momentum indicators such as the relative strength index (RSI) measure the speed at which a security's price is changing. One of the main advantages of such indicators is the early signaling for entry and exit points. However, along with their strengths, they do exhibit some limitations.
With that in mind, I designed a new mode of RSI with self-adjusted overbought-oversold benchmarks. The advantage of this is that it could be applied to multiple market conditions without regard to the calculation period. The basic advantage of the indicator is that it expands the functionality to intermediate and long terms, squeezing its way into the traditional domain of trend-following indicators and making it possible to use it in multiframe analysis.
LIMITATIONS IN THE RSI
The application of the popular RSI is conventionally limited to short-term analysis. But detecting a tradable's strength in the intermediate and long terms is an issue that is just as important, if not more. As you are probably aware, the RSI fluctuates around a centerline and highlights overbought and oversold extremes relative to the 30 and 70 benchmarks. But it is usually more accurate when calculated using a 14-day period. Anything beyond tends to yield errors.
If you take a look at Figure 1, you'll see the percentage of RSI values that fall outside the conventional overbought-oversold range (30-70%) for the Russell 3000 index. As you can see, beyond the conventional 14-day period, the RSI deviates from the accepted percentage of values (20-30%). This is how much they are supposed to extend from the overbought-oversold levels in order to provide reliable readings of the extremes. The error increases with mid-term and long-term periods, where the 30-70 levels are too wide for the narrowed RSI curve. This causes it to miss most of the overbought and oversold signals.
FIGURE 1: LIMITATIONS OF THE RSI. When using a periodicity other than 14, the RSI (beyond the oversold/overbought levels) deviates far from acceptable levels.
...Continued in the February issue of Technical Analysis of STOCKS
& COMMODITIES
Excerpted from an article originally published in the February 2006 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2006, Technical Analysis, Inc.
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