Disclaimer: This post is not meant to serve as financial advice. It is only meant for information and educational purposes. Nullbeans.com, its owners and writers are not financial advisers and are not responsible for any financial decisions or actions you or others perform due to information in this post.


In this post we will discuss what the Relative Strength Index (RSI) is, what it tells us about a stock or a commodity, which signals does it provide us and how to use it to our advantage during trading.

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What is the RSI

The RSI is a technical indicator used to analyse a specific commodity in a financial market. The indicator measures the “strength” with which price changes occur. This means that it’s value is based on measurements of the speed and size of the price movements. That is why the RSI is considered a momentum oscillator.

Example of the 14 day RSI plotten on a chart. Credits: tradingview.com
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The indicator can have any value from 0 to 100. The higher the value, the more “overbought” a commodity is considered. The lower the value, the more “oversold” the commodity is. Traditionally, the thresholds for overbought and oversold are values above 70 and below 30 respectively. However, this does not always mean that a stock or commodity will fall or increase in price in the short term, as we will see in the next few sections.

It is common among traders to use the 14 day/candle RSI. This will base the RSI value on the previous 14 days / candles on the chart. However, a 7 candle and a 21 candle chart are also common. As the lower the number of candles used, the more sensitive the indicator will be. However, with smaller number of candles come more false flags.

In contrast, the 21 candle RSI will provide more reliable signals, but will be less sensitive and produce less signals. In our examples, we will use the 14 day RSI.

Overbought and oversold conditions

In order to understand how the RSI works and how it can be used, we first need to discuss the conditions that could cause the value of the RSI to shift to the high or low extremes.

Overbought conditions

When a commodity is overbought, there is a high probability that the prices will experience a sharp drop in the near future. This is due to profit taking by investors who bought before the prices experienced a sharp increase.

Overbought conditions are usually a result of investors jumping in on a commodity that is experiencing a rapid increase in price. This is usually called FOMO or “Fear Of Missing Out”. These investors buy what they can of the commodity, resulting in an even more rapid increase in price. This results in an overbought conditions which prompts earlier investors to sell to cash in on the large price increases.

It is common for the RSI to have a value above the 70 threshold when the commodity is overbought.


As you can see from the previous chart, the price often (but not always) drops after the RSI reaches the 70+ range.

Oversold conditions

Similarly, when a commodity is oversold, there is a high probability that the prices will experience a sharp rally in the short term. Oversold conditions occur due to various reasons. For example, when a large number of investors set their stop losses at a physiological level such as “100”, “2000” and so on. A sharp and sudden move downwards can cause a cascade of automatic sell orders, causing the price to dip even further. Add to that panic selling and you have even further dips in prices, triggering more stop losses.

When such scenarios occur, we often see the RSI dipping in value, usually below the 30-40 range, indicating that we have reached oversold territory. It often also happens that prices experience a rally after that, as investors realize that a commodity is under-priced and they can enter in new positions “at a discount”. As you can see from the chart, a sharp drop in the RSI usually accompanies a short term rally in the price.

Why you should not rely on RSI alone

So far we have discussed how the RSI behaves when prices move with strong momentum to the up or down side. However, it is not always the case that a price drop occurs immediately after a +70 RSI rally, nor does it always happen that a rally occurs when the RSI dips below 30.

Take for example the following chart from the price of silver. Even though the RSI was over the 70 value, the price kept going up to gain an additional 30%!

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Had you have sold at that point, you would have missed an opportunity for additional profits. Similarly, Take a look at the following chart.

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In the chart, we can see that the price had a sharp price drop and an RSI below 30. However, a subsequent rally failed to materialize and further drops occurred.

So does this mean that the RSI is a useless indicator? Of-course not!. This only tells us that the RSI is one of several tools that should be used together in order to paint the complete picture about future price actions.

Trading strategies and signals involving the RSI

In this section, we will discuss several strategies where the RSI can prove to be a useful indicator along with other indicators that can give us more confidence when making a trade.

Using the RSI to find divergence

The RSI can be used to identify a bullish or a bearish divergence. A divergence signals a change in the market trend. Take the following chart for example.

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In the chart above, we can see that even though the prices kept going lower, the RSI kept going higher. In other words, the RSI is setting higher lows, while the price is setting lower lows. This is an indication of a bullish divergence as the RSI is indicating that the commodity will have a trend reversal to the upside.

We can combine this signal with the 50 day and 200 day moving averages to confirm the bullish trend. In the chart, the prices first crossed the 200 day moving average, indicating a break of the resistance trend. The price then stayed above the 200 day moving average and the 200 day MA started to behave as support. Finally, we obtained a golden cross when the 50 day crossed the 200 day MA, indicating a bull market.

All these signals combined give us a high probability indication that an entry for long position will be profitable.

Similarly, in the case of a bearish divergence, the price movements will not match the movements in the RSI. We will notice that the RSI will move lower while the price stays the same, or increases. This should serve as a warning signal that a price drop or a bear market is around the corner.

An example of the bearish divergence. Click to enlarge


Combining the RSI with resistance/support lines

In a trending market, where prices keep on setting lower lows, lower highs, higher lows, or higher highs, for example in bull or bear markets, we can use the RSI in combination with resistance or support lines to time our long and short positions.

Take for example the following chart from the silver market. The commodity has been experiencing a bear market for more than two years, consistently setting lower highs. If we plot the 200 day MA, we see that it is acting as resistance. Instead of just using the MA as an indicator, we can combine it with the RSI to time our short positions.

Chart highlighting the 200 day MA resistance line in a bear market and possible short positions.
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As you can see, combining the 200 day MA resistance line with an RSI larger than 70 gives as a high probability signal that a price drop is imminente and that a short position would be profitable.

Similarly, in a bull market, we can also time our long positions when the RSI dips below 30-40 and the price is near a support line, such as the 200 day MA.

click to enlarge



Limitations of the RSI

The RSI is a very powerful indicator as seen above. However, please keep in mind that it is also a lagging indicator. This means that its current value is based on past data and does not guarantee any future price changes. Therefore, it should only be used in combination with other indicators.

Some traders like to draw trend lines in the RSI chart to predict price action movements. However, I found that this can be an unreliable strategy. It feels like seeing shapes in the clouds. It is not that the clouds look like a cat, it is that you see the parts of the cloud that make you think it looks like a cat!

It is also very important to note that the RSI can be very unreliable on shorter time frames such as the 1 and 5 minute candles. It is better to use it with longer time frames such as the 1 hour and above for more reliable signals.

Finally, as mentioned before, it is best to use the RSI when there is a trend in the market. For example, during a bull marke, or during a bear market. However, if the market is trading sideways and there is no clear trend, then it is likely that you will receive more false signals from the indicator.

Summary

In this tutorial, we discussed what the RSI indicator is and how it can be used to make high probability trades. We discussed how to use the RSI to find divergences and how to combine it with the SMA to make market moves. We finally discussed some of the limitations of the RSI.