It’s not surprising to know that most people use RSI indicators in the wrong way. Yes! You heard it right. Most indicators we use are derived from price and are pure lagging indicators. Even the momentum indicators are the derivatives of price and volume.
Hence these indicators cannot show the future direction but may give a sense of future momentum. Confused? I know you are confused. By the time you complete reading this article, you will understand what I am saying and will have a good understanding of the indicators.
The most common indicator that many traders use is RSI or Relative strength indicator.
What is an RSI indicator?
Investopedia defines the Relative strength index as a momentum indicator used in technical analysis to measure the magnitude of recent price changes to evaluate the over-bought and over-sold conditions of a stock or index.
In simple words, it is a graph that represents the over-bought or over-sold zones of a stock or index considering the past 14 periods.
The indicator was developed by J.Welles Wilder Jr in 1978. According to J.Welles, any value of RSI above 70 is an indicator that tells that the stock is overbought. Hence it is an indicator of a trend reversal.
Any value below 30 in the chart indicates that the stock is oversold, and that trend may reverse from here.
I am not going deep into the formula for calculating RSI as I know NO ONE WILL BE INTERESTED IN UNDERSTANDING THE FORMULA.
How do we use RSI?
Many traders use a Relative strength indicator with few modifications for their use. Here are a few concepts of trading using RSI. But remember this might not be the right way to use it. But still, try to understand these concepts as they may help you in your trade.
Concept 1: adjusting overbought and oversold zones.
Few traders adjust the oversold and overbought zones. For example, many traders consider any level above 80% as overbought, instead of 70%.
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Similarly, any value below 20% is considered as oversold zones instead of 30%.
The above adjustments have some advantages and disadvantages. These changes help in increasing their accuracy in predicting the direction. But on the other hand, the percentage of accuracy is not up to the mark. Only 30 to 40% of such predictions have come true.
Concept 2: Midline trend
Few traders draw a midline (A 50% line) between 30% and 70%. During an uptrend, the Relative strength value above this midline indicates that the trend is upward and there are more changes that the price will move still higher.
During a downtrend, the value below this midline is an indicator of the continuation of the downtrend.
When the RSI value crosses the midline, it is an indication of a trend reversal.
Limitations of RSI
The relative strength indicator is a momentum indicator, but it is a derivative of price momentum. Hence it cannot be a leading indicator.
In simple words, it cannot predict trend reversal much before the price action. Hence, people using RSI cannot enter the game at the correct time.
Moreover, the indicator gives more false alarms. For example, an index or a stock can be in over-bought or over-sold zones for a full day or even for multiple days.
Hence any trader, thinking of it as an overbought zone, might sell the stock. Unfortunately, the price will move still higher and will end up in losses. Hence we should think that RSI is not a reliable indicator.
The above picture shows, that the RSI has stayed for a long duration in an overbought zone. But still, we did not find any trend reversal. Any trader who sells the stock by seeing such a picture might end up in huge losses.
Hence what we understood from RSI limitations are
- RSI gives a higher number of false signals than true trend reversals.
- It may stay in oversold or overbought regions for longer periods. Such scenarios may throw the traders into severe losses.
- RSI produces more noise than the direction in highly volatile markets. Hence avoiding this indicator in volatile markets is a best practice.
The correct way to use RSI
Do you know that RSI is a good indicator for predicting the long-term trend? Yes! You heard it right.
Instead of focusing on the oversold and overbought zones, if we can analyze and compare the momentum of RSI to the momentum of price, we may get good predictions.
For example, any divergence or convergence of the RSI with the price movement can help us in identifying a trend reversal.
Here are a few examples.
RSI DIVERGENCE
In the above picture, when the price is moving up, the RSI is moving down, this is called RSI divergence.
Hence, we can predict that there is a false price movement and the trend can reverse at any time. Professional traders stop entering at such positions as they are losing traders.
RSI CONVERGENCE
The above picture shows that even though the price is decreasing the relative strength is increasing. It indicates a trend reversal.
Hence, we can see a reversal in price and it started moving up.
Conclusion:
RSI convergence and divergence are good predictors of trend reversals. The traditional way of using this indicator has more false predictions.
But, I have to say that, even the relative strength indicator convergence and divergence may produce false positives and false negatives at times. Hence RSI should always be backed with price action and support and resistance zones for the proper prediction of the trend.
For example,
AN RSI CONVERGENCE AT A SUPPORT ZONE IN THE GRAPH MAY GIVE MORE ACCURATE RESULTS. SIMILARLY, A RSI DIVERGENCE AT A RESISTANCE ZONE CAN GIVE A MORE ACCURATE TREND REVERSAL POINT.
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