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Buy calculating the relative strength of stocks, you gain a perception of a stock’s performance in relation to similar stocks in the same industry. Stocks with the greatest strength tend to out perform the market and experience price increases and growth. However, stocks with relative weakness can lose share values in the long term. To calculate a stock’s relative strength, you must use the relative strength index (RSI), which market expert J. Welles Wilder developed as a measure of stock performance and an indication of future probabilities.
Establish an evaluation period for which you will calculate your stock’s relative strength. Traditional RSI calculations use a 14-day trading period, although you can choose any interval you want.
Calculate the share price changes for the stock for each day of your evaluation period by determining the difference between each day’s closing share price and the previous day’s closing share price. Record each day’s price change for the entire evaluation period.
Add together and record the total of the positive price change days. Divide that total by the number of days in your evaluation period to find the average positive daily price change.
Add the together and record the total of the negative price change days. Divide that total by the number of days in your evaluation period to find the average negative daily price change.
Divide the average positive daily price change by the average negative daily price change to find the RS number.
Use your RS number’s value in Wilder’s relative stock index equation, RSI = 100 - 100 X 1 / (1 + RS). The resulting number will fall between 0 and 100, which represents the stock’s relative strength. Higher numbers indicate stocks with the greatest strength.
Wilder’s model suggests that relative strength values that fall quickly -- specifically in the range below 30 -- may represent oversold stocks due for a rally. Similarly, relative strength values that rise quickly -- specifically in the range between 70 and 100 -- can represent overbought stocks due for a future price correction.
Relative stock changes each day as share prices rise and fall. Recalculate a stock’s relative strength daily by adding each day’s price changes and removing data from the oldest day in the evaluation period.
The relative stock index represents just one of many stock indicator tools useful in selecting and holding profitable stocks. Traders should avoid choosing a stock based on a single indicator, and should instead compare stocks against multiple stock indicator tools.
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