Dear Traders, There is Magic in RSI

1. RSI Reveals Market Secrets

'I haven't found anything in over thirty years of work that can hold a candle to what RSI can do.' -Andrew Cardwell

RSI's predictive power. The Relative Strength Index (RSI) is a powerful tool for traders, offering insights into market momentum and potential turning points. It's not just another indicator; it's a leading indicator that can provide clues about future price movements, helping traders make informed decisions about when to buy and sell. RSI's ability to predict prices and identify entry and exit points makes it a valuable asset in any trader's toolkit.

RSI's unique appeal. What sets RSI apart is its ability to provide a comprehensive view of market dynamics. It can tell you whether the price is likely to go up or down, warn you of trend changes through divergences, and give you trend continuation signals through positive and negative reversals. RSI can even help you set price objectives for reversals and accurately predict breakouts in channels or patterns.

RSI's practical applications. RSI can help traders determine what to buy, when to buy, and when to sell. By using a screener on RSI signals, traders can identify good buying options. This makes RSI a versatile tool that can be used in a variety of trading strategies, from short-term day trading to long-term investing.

2. Navigating the Challenges of RSI Trading

'The RSI indicator is a cruel mistress! She lures us in with promises of easy money and trading success, only to drain your trading account balance in a run of terrible stoploss strikes, even though the indicator said BUY! The RSI indicator is usually the go to oscillator for the novice trader when deciding to enter that first trade. There is a simple, valid reason for this: The RSI indicator is simple to read and understand.' -From Humbletraders.com article

Hidden complexities. While RSI may seem simple at first glance, it's a complex indicator with hidden challenges that many traders overlook. These challenges include the lack of RSI studies in the Indian context, the scarcity of books dedicated solely to RSI, the challenge of choosing the right timeframe, and the challenge of selecting the appropriate RSI period.

Context matters. Trading on the basis of RSI requires a deep understanding of these challenges and how they can impact trading outcomes. For example, RSI techniques developed for U.S. markets may not work in the Indian context, and RSI readings can differ on different software platforms, leading to confusion and potentially incorrect trading decisions.

Deep dive needed. To succeed with RSI, traders need to dig deep and understand its secrets. This includes understanding how RSI is calculated, why it gives divergences, and why it's considered a leading indicator. By mastering these aspects of RSI, traders can increase their odds of success and avoid the pitfalls that trap novice traders.

3. The Birth and Purpose of RSI

RSI measures momentum – momentum is perhaps the most important factor in trading. If you understand momentum, you are 90% of the way home.' -Paul Dean

Wilder's invention. The Relative Strength Index (RSI) was invented by J. Welles Wilder, who described it in his book 'New Concepts in Technical Trading Systems' in 1978. Wilder, a mechanical engineer turned technical analyst, created RSI to help him find the right timing for his trades, specifically when to buy and sell stocks and commodities.

RSI as a momentum oscillator. RSI is a momentum oscillator measured on a scale from 0 to 100. High and low levels are marked at 70 and 30, respectively, indicating overbought and oversold levels. The default period for RSI is 14 days in a daily chart.

RSI's predictive potential. Wilder believed that RSI has the predictive potential to tell in advance when a stock is getting strong or weak. As a leading indicator, RSI can give significant clues about future prices, allowing traders to anticipate market movements and make informed trading decisions.

4. Decoding RSI Calculation

'The trend is your friend UNLESS it is about to end.' -Thomas DeMark

Closing price focus. RSI is calculated based on the closing price of a bar or candle. It gives a ratio of gains and losses for a period of 14 days. If there are more gains, RSI will be higher; if there are more losses, RSI will be lower. The amount of gains or losses is also important, and RSI is calculated exponentially, giving more weight to recent price moves.

Anti-trend bias. RSI has an anti-trend bias at extreme zones, meaning it reacts wildly to anti-trend prices around overbought or oversold zones. This is because RSI gives slow movements on trending prices and fast movements on anti-trend prices, especially in overbought and oversold territories.

Divergence explained. Divergence occurs when price and RSI are moving in opposite directions. Bullish divergence occurs when price makes a new low, but RSI makes a higher low. Bearish divergence occurs when price makes a new high, but RSI makes a lower high. Divergences predict trend reversals well in advance, indicating that the primary trend is becoming weak and the secondary trend is becoming strong.

5. Top 10 RSI Signals for Traders

"Whether you are a seasoned trader, or a brand new trader, learning the key concepts of the RSI, Relative Strength Index, is perhaps the most important thing you can do to advance your trading career.” -Paul Dean

RSI's signal variety. RSI provides a range of signals that traders can use for trading purposes. These include tops and bottoms, failure swings, support and resistance, centerline crossover, range shift, channels and trendlines, chart patterns, 9-day RSI average crossover, divergences, and reversals.

Tops and bottoms. According to Wilder, tops and bottoms are indicated when the RSI goes above 70 or below 30. RSI gives an indication of overbought and oversold conditions, so the simplest thing in the world would be to buy a stock, when its RSI reverses from 30 levels and sell it when its RSI reverses from 70 levels.

Failure swings. When RSI does not exceed its previous high at overbought or oversold levels, it is called a failure swing. Failure swing signal is confirmed, when RSI drops below the valley in M-formation or it rises above its preceding peak in W-formation. Failure swing is considered more significant, when it takes place within the oversold or overbought zones.

6. Divergence as a Key Indicator

'Divergence is the single most indicative characteristic of the Relative Strength Index.' - J. Welles Wilder

Divergence defined. Divergence occurs when price and RSI are moving in opposite directions, indicating non-confirmation. Bearish divergence occurs when price makes higher high and RSI makes lower high. Bullish divergence occurs when price makes lower low and RSI makes higher low.

Divergence as a powerful signal. RSI divergence is a signal that RSI has reached overbought/oversold levels and that the momentum is changing and the current trend is weakening. Due to its anti-trend bias, RSI alerts traders about the possibility of trend reversal or at least retracement.

Multiple divergences. RSI can give more than one divergence, and frequently does so. Don't rush in to buy after seeing the first divergence. RSI gives at least two divergence signals and only then the trend reverses. Three RSI divergences in close succession are enough to change the direction of the price.

7. Reversals: Trend Continuation Signals

'If you pick up only a single notion from this book. let it be the following: When an oscillator advances or declines disproportionately to the markets' movement, you are on the wrong side of the market if you are positioned with the oscillator.' - Constance Brown

Reversals vs. Divergences. Reversals are different from divergences; in fact, they are just the opposite. Divergences signify trend reversals, while reversals signify trend continuation. Positive reversals occur in uptrends, while negative reversals occur in downtrends.

Positive and negative reversals. A positive reversal occurs when price makes a higher low while RSI makes a lower low. A negative reversal occurs when price makes a lower high while RSI makes a higher high. Reversal patterns are primarily useful for trend traders, as the occurrence of this pattern signals that prices have made a corrective retracement in a larger trend -- and that the trend is ready to resume.

Calculating price targets. Positive and negative reversals are preferred by traders, as here you can set targets and stop losses, which is difficult in the case of divergence. The price target formula for a positive reversal is Price Target = (X-W)+Y. The price target formula for a negative reversal is Projected price target = Y-(W-X).

8. Limitations of RSI

'Markets tend to operate in a trading range 70-75% of the time and trend 25-30% of the time. Consequently, any moving average time period should be equally effective in a trending market and no moving average is effective in a trading range market. Conversely, oscillators that identify areas of overbought and oversold are most effective in trading range or sideways markets.'- Thomas DeMark

RSI's constraints. RSI, like any other indicator, has its limitations. It does not work well in trends, illiquid or low-float scrips, operator-driven stocks, or stocks with very high volatility. It is calculated only on the basis of closing prices, so day highs or day lows will not be counted, even if such price movements are significant.

False signals. RSI may give false or disproportionate signals, especially in anti-trend direction. A small anti-trend price action may cause major movement in RSI. Also, RSI on various sites give different readings, so ensure its correct reading.

Subjectivity. Use of RSI is very subjective. Trader's experience plays a crucial role. In a nutshell, RSI gives us the snapshot of bear-bull power balance. Whenever there is momentum shift due to some significant news, RSI alerts us about it before price action. It is very sensitive to any changes in momentum.

9. Choosing the Best Timeframe for RSI

'Well, I use 14-period on a monthly, weekly, daily, hourly, 15-minute chart, 5-minute chart. The rules don’t change depending on the temperament and investment objective of a trader.' -Andrew Cardwell

Timeframe challenge. There are so many timeframes that you get different RSI signals regarding buy, sell or hold. When there are 12 timeframe charts, naturally there would be 12 different RSI levels of a single stock or index at any point of time.

Timeframe guidelines. For day trading, use 5 minute chart or 15 minute chart. For swing/positional trading, use 1 hour chart. For short term trading (less than a year), use daily chart. For Long term trading (more than a year), use weekly chart.

One level up, one level down. Always consult the charts of one level up and one level down. It means that if you are trading on the basis of daily chart, you should also look at one level up (in this case, weekly) and one level down (1 hour chart) to filter the noise and get proper perspective.

10. Popular RSI Trading Strategies

'At best you may achieve a 60% win rate with any strategy, including one with the RSI.' -Tradingsim.com

RSI strategy variety. There can be dozens of ways to trade with RSI. Traders use RSI to their advantage, either independently or with the help of some other tool/indicator.

Confirmation tools. RSI alone is a mighty force, but it has so many facets that we can easily misunderstand its message. It is necessary to confirm RSI signals by other indicators or signals. These eight confirmation tools are generally used in RSI trading: Price trendline and RSI trendline, Horizontal support and resistance level, Bollinger Bands, Moving average crossover, Moving Average of RSI itself, Bullish or bearish candles at critical junctures, Higher timeframe chart, and Volume.

Aim for 50% success. Most of the retail traders want 100% success rate, which is impossible in stock market. Traders should aim at the target of 50% success rate. Be prepared that you will be wrong 5 times out of 10 in your trades. This would compel you to make a better strategy, where you will let your winners run and cut short the losers.

Last updated: April 5, 2025