Today’s technical analysis trader has an unbelievable assortment of indicators to assist in forecasting a stock trend.
This is a new phenomenon. Many investors started in the markets before the personal computer became popular. Technical analysis consisted of studying long term paper charts published in book form.
This forced early investors to make the most of whatever indicators the publishers would print.
Any real time charting would need to be done by hand on graph paper with a data feed coming from the precursor of CNBC, FNN or, if you were fortunate, a FM radio transmitter from a company called Data Broadcasting Corporation or DBC.
Original modern technical analyst’s were limited to just a handful of indicators such as the moving average and volume. Times have changed dramatically with the advent of the PC. Now it’s a matter of weeding out the countless indicators of uncertain value to focus on ones proven to have value.
One of the most widely used indicators of all time is the Relative Strength Index or RSI.
RSI is an oscillating momentum indicator created by Welles Wilder and first popularized in his 1978 Technical Analysis book “New Concepts In Technical Trading Systems”. I strongly recommend this book for those of you who want to dig deeper into the RSI idea.
It’s usually used by traders in line chart form to determine if a trading vehicle is overbought or oversold. It compares increasing price movement to decreasing price movement over a specific time frame.
This figure is displayed as a line on a chart, moving between 0 and 100. 30 and below is considered “oversold”, 70 and above is considered “overbought”.
The way it works is that when the line goes above 70 it means to look to sell as all the buyers are thought to be already in. Below 30 means that everyone has already sold, and it’s time to buy as all the selling is complete.
Mathematically, RSI is the ratio between the upward and downward price moves normalized into a value that falls between 0 and 100.
For those quants reading this , the equation for RSI is 100-100/(1 + (total gains/n)/(total losses/n). N is the total number of RSI periods. Wells Wilder taught that 14 is the standard number of periods to use. Most programmed RSI TA indicators use 14 as the default number of periods.
While 14 is the standard time periods used in RSI calculations, there have been several studies that indicate that it is not the ideal number to use.
A recent study that I read clearly proved that 2 periods is the ideal number for RSI readings.
My suggestion is to experiment and back test with different parameters to determine what works best for your time frame and investment style.
Source: http://tradingtips.com/daily/day-trading/the-most-popular-stock-market-indicator-of-all-time/