Does the Relative Strength Index Really Reveal Buying Opportunities?

As a technical analysis tool, the Relative Strength Index (RSI) uses a formula to indicate if a stock is overbought or oversold. To do so, the RSI number, which ranges from 0 to 100, factors in the speed and magnitude of the stock’s price changes. Most investors consider an RSI of 70 or higher to indicate that the stock is overbought and that an RSI of 30 or less indicates that it is undersold.

Author Welles Wilder, Jr. first proposed the measurement in his 1978 book, New Concepts in Technical Trading Systems. Since then, it has been a popular tool among a cohort of investors seeking to apply a mean reversion strategy.

By analyzing the stock’s performance relative to its own price history, investors might have an opportunity to get in and out of a security at the right times and maximize their gains.

But does it actually work?

This has been a debate for a long time, perhaps since Wilder’s 1978 publication. Proponents of the RSI often argue that the calculation is useful for identifying short-term buying and selling opportunities and that the formula removes the subjectiveness and emotion that can often lead to bad decisions.

Detractors argue that the RSI ignores important qualitative information like the competitive standing of the company or new products that could boost the business’s earnings - and therefore share price. Additionally, making frequent trades is not tax-efficient and can result in burdensome trading fees.

The question remains, does the RSI provide accurate buy and sell signals? Here we attempt to answer that question.

Does The RSI Give Investors an Advantage?

The Study:

Quantitative researchers at Analytics Vidhya published some interesting research investigating the value of the RSI as an investing tool.

The data, available on Medium, tests three scenarios:

First, the research explores how an investor would have performed if they bought and held shares of the S&P 500 when it was at an RSI below 30 indicating that it’s oversold and therefore “cheap.”

Second, it examined what would happen if the investor bought and held shares of the S&P 500 when the RSI was under 70 indicating that it’s still not overbought and therefore “not expensive. 

Third, it looked at what would happen if the investor bought the S&P 500 every time the RSI was under 30 and sold it every time the RSI was over 70. This was the “buy cheap, sell expensive” strategy. 

The benchmark for success was whether or not each strategy outperformed a simple buy and hold strategy. These three strategies and the buy and hold benchmark were tested over four periods, 1 year, 3 years, 5 years, and 10 years using data going back to 1960.  

The Results:

There are three key takeaways from the analysis.

First, the “buy cheap, sell expensive” strategy consistently had a lower mean ROI than the other strategies including the simple buy and hold benchmark. Interestingly, there was one benefit to this strategy: the standard deviation was also lower, “which maybe makes the ROI more predictable,” according to the research.

Second, the ROI was very similar across the “buy cheap,” “not expensive,” and the benchmark buy and hold strategy. However, the “buy cheap” strategy underperformed over the 1 year period because in bullish years there were no cheap prices to be had.

Third, the buy and hold strategy was a very effective approach given that it generated “an average ROI of 8%, 25%, 46%, and 110% for the four horizons respectively.”

Benchmark Strategy

Buy and Hold

Source: Analytics Vidhya 

RSI Strategy

Buy Cheap and Sell Expensive

Source: Analytics Vidhya

What stands out from a quick glance at the two charts above is that the RSI strategy appears to outperform starting at about the 2010 mark. 

This might suggest that there is a characteristic of the modern market that is more agreeable with the RSI strategy. That said, more analysis is necessary to verify if that assumption is true.

A look at the last 12 months of data shows that the RSI of the S&P 500 has been hovering around 50 indicating that it is not oversold or overbought. However, a closer look reveals that just after reaching overbought territory (red) and oversold territory (green) the S&P 500 responded as expected with a drop after becoming overbought and a rise after becoming oversold. 

While the long-term data shows that a pure RSI strategy underperforms a traditional buy and hold approach, the recent data indicates that in the short term, there is some merit to the idea that the RSI can offer meaningful guidance.

Source: Aiolux

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc. or Trackinsight. Past performance is not indicative of future results. Investors should undertake their own due diligence and carefully evaluate companies before investing. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.