Is the Trend Really Your Friend? Ask RSI

Editor's note: With this column, we introduce Dan Fitzpatrick, a managing partner of Strathmore Capital, a private hedge fund in Englewood Cliffs, N.J. His column will focus on quantitative strategies for investment and trading. As always, give us your thoughts.

The market ain't what it used to be. The only obvious trend is that there is no trend. I look at hundreds of charts each day, searching for tradeable trends in indices, sectors or individual stocks. But what seems oversold one day is overbought two days later. You can feel the lack of conviction in the daily price action. Even when you do happen to spot a trend, how can you be certain that the trend won't stop on a dime just after you've committed to the trade?

One indicator you should check is Wilder's Relative Strength Index, or RSI. RSI measures a stock's strength relative to itself, by comparing the most recent price action with prior price action for the same stock. By comparing the RSI trend with the stock's trend, you can spot divergences that signal when the stock's trend is about to change.

One of the biggest advantages of RSI is its ability to filter out the noise caused by volatility and, instead, produce a smooth signal. RSI compares the total price gains for periods when the stock closed higher against total price declines for periods when the stock closed lower. The RSI signal is smooth because it averages these figures over a specific period of time -- in this case, 14 days. (For a detailed explanation of the RSI formula, refer to Technical Analysis of the Financial Markets, by John J. Murphy.)

RSI for Trend Strength Assessment

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