Understanding Momentum Indicators and RSI

Every book dealing with the subject of technical analysis devotes at least a couple of chapters discussing both momentum and the relative strength index (RSI). For those of you not familiar with price momentum and the RSI, you need to know that J. Welles Wilder (who created the index in the late 1970s) first wrote about the subject in the classic "New Concepts in Trading Systems."

To understand how these two indicators can be used together, we must first, for a moment, review each of them.

Momentum is the measurement of the speed or velocity of price changes. In "Technical Analysis of the Financial Markets," John J. Murphy explains:

"Market momentum is measured by continually taking price differences for a fixed time interval. To construct a 10-day momentum line, simply subtract the closing price 10 days ago from the last closing price. This positive or negative value is then plotted around a zero line. The formula for momentum is:

M = V - Vx

V is the latest price, and Vx is the closing price x number of days ago."

Momentum measures the rate of the rise or fall in stock prices. From the standpoint of trending, momentum is a very useful indicator of strength or weakness in the issue's price. History has shown us that momentum is far more useful during rising markets than during falling markets; the fact that markets rise more often than they fall is the reason for this. In other words, bull markets tend to last longer than bear markets. (To learn more, see: Banking Profits in Bull and Bear Markets.)

The relative strength index was created by J. Welles Wilder Jr. in the late 1970s; his "New Concepts in Trading Systems" (1978) is now an investment-lit classic. On a chart, RSI assigns stocks a value between 0 and 100. Once these numbers are charted, analysts compare them against other factors, such as the undersold or underbought values. To reach the best evaluation, experts generally chart the RSI on a daily time frame rather than hourly.  However, sometimes shorter hourly periods are charted to indicate whether it is a good idea to make a short-term asset purchase. (See also: Who developed the relative strength index (RSI)?)

There has always been a little confusion over the difference between relative strength, which measures two separate and different entities by means of a ratio line, and the RSI, which indicates to the trader whether or not an issue's price action is created by those over-buying or over-selling it. The well-known formula for the relative strength index is as follows:

RSI = 100 - (100 / 1 + RS)

RS = Average of x days' up closes / Average of x days' down closes

At the bottom of the RSI chart, settings of 70 and 30 are considered standards that serve as clear warnings of, respectively, overbought and oversold assets. A trader with today's simple-to-use software may choose to reset the indicators' parameters to 80 and 20. This helps the trader to be sure when making the decision to buy or sell an issue and not pull the trigger too fast.

Ultimately, RSI is a tool to determine low-probability and high-reward setups. It works best when compared to short-term moving-average crossovers. Using a 10-day moving average with a 25-day moving average, you may find that the crossovers indicating a shift in direction will occur very closely to the times when the RSI is either in the 20/30 or 70/80 range, the times when it is showing either distinct overbought or oversold readings. Simply put, the RSI forecasts sooner than almost anything else an upcoming reversal of a trend, either up or down. (If you want more details, check out: An Introduction to the Relative Strength Index.)

[The RSI and momentum indicators are just a few examples among many tools that you can leverage in stock chart analysis. To learn more about the technical indicators that can serve as the backbone of a successful trading strategy, check out the Technical Analysis course on the Investopedia Academy.]

Both indicators are very reliable on their own, but what would happen if we decided to put the two of them together? The result offers even better timing with our entry and exit points. Let's have a look.

In the first chart, we have inserted a momentum indicator with a 12-day period. In the second chart, we compare the stock during the same time frame and lay the RSI indicator across the bottom of the space. The RSI in this example is also a 12-day period.

The first look at the stock shows momentum rising over the zero line in the first week of December. We have shown this on the chart with blue up arrows. This entry signal is not long lived, as the momentum turns a week later and heads south in a hurry to finish the year at about the $22 level, shown with red down arrows. The next entry level is not seen until the first week in February of 2003, again shown with blue up arrows. For the most part, the momentum does not fall below the zero line with any conviction from that week on until the week of June 23. During this period of time, the stock price moves from the $21 level to the most recent close of $32.47.

Chart created with Tradestation

The second look at the stock, which shows the RSI indicator, has a slightly different look from the momentum chart above. First off, there is a weak entry point in early January and then a few weeks later a somewhat stronger entry point, which for the most part continues throughout the winter and on into the spring. You can see that, after the blue up arrows (entry points) we have drawn in the early part of the year, there are three sets of red down arrows (exit points) during mid-March, again during the second week in May and again in the third week of June.

It is important to recognize that many traders view the RSI value of 50 to be a support and resistance benchmark. If an issue has a difficult time breaking through the 50-value level, the resistance may be too high at that particular time, and the price action may fall off again until there is enough volume to break through and continue on to new levels. An issue falling in price may find support at the 50 value and bounce off this level again to continue an upward rise in price action. (For more information, see: Support and Resistance Reversals.)

Chart Created with TradeStation

This study of this stock demonstrates an interesting look that traders should consider when using oscillators for entry and exit points. In the second chart, the weak entry point in early January is not even reflecting a buy signal in the first chart, which uses momentum. In conclusion, traders should disregard the entry signal. However, the second entry signal issued a few weeks later by the RSI is confirmed a week later with a strong buy signal from the momentum indicator rising above the zero line.

Another important note is that, even though there are three exit signals shown on the RSI chart, the momentum does confirm sell signals, and the stock continues to rise with short-lived pullbacks. The sell signal on the RSI chart during the third week of June is confirmed with the momentum indicator falling off sharply at the same time and dropping below the zero line.

Double confirmation of entry and exit points gives traders a better understanding of whether or not they are getting in or out at the right time. And timing is everything in this game. (For additional reading, check out: What are the best technical indicators that complement the Relative Strength Index (RSI)?)