The relative strength index (RSI) is one of the most common used oscillators. It is based on the concept that the price of a financial instrument cannot rise or fall for long periods without correcting or even reversing its prior trend. That’s why RSI signifies overbought areas after a relatively prolonged uptrend and oversold areas after a relatively prolonged downtrend.
Its mathematical construction is based on price changes during a certain time period. The classical Wilder’s RSI(14) has an upper zone from 70 to 100 which signals that a financial instrument is overbought and a lower zone from 0 to 30 which signals oversold. It is a bounded oscillator and it oscillates between 0 and 100. Its mathematical type is:
The word ”relative” means relatively to the previous price action of the same stock and not in comparison to another stock or financial instrument. Traders and technical analysts use RSI in many different ways but some properties are unanimous acceptable. The most common uses of the classical RSI(14) are:
1.Upward breaking of the 70 line
When it breaks upwards the upper line of 70 the chances are that the stock will soon reverse its uptrend, so someone must be prepared to sell or short sell because the stock is overbought. We do the same but inversely when it breaks downwards the lower line of 30.
2. Upward breaking of the 70 line and entry on the next breakdown of the same line
After breaking upwards the 70 line we sell when it breaks downwards the same line in order to partially confirm that the previous trend is reversing. We do the same but inversely after breaking downwards the lower line of 30.
As every oscillator, it performs poorly when we have a strong trend. In that case it constantly produces false signals and it tends to stay for long periods in the overbought or oversold areas (circled area in SPY daily chart below).
RSI positive divergence in MAS
RSI negative divergence in SLB
Another critical matter relatively to the proper use of RSI is the redefinition of the upper and lower limits in order to better correspond to the particular stock or financial instrument and market conditions. The optimal upper limit might not be 70 but 85 and the lower 40 if the market generally is in an uptrend whereas, when the market is in downtrend the upper might be 65 and the lower 25. Also the optimal time period should be applied, which is not necessarily 14. This can be done by empirically testing different RSI periods on a price chart, or even better by back-testing.
As it is obvious, many practical considerations should be taken into account before someone uses RSI as a supplementary technical criterion and of course the trader should check if the price chart of a particular stock ”respects” RSI no matter if it is a daily or 5 minutes chart.
RSI can be so subjective depending on the technical analyst, that some traders use it inversely from the classical approach. They buy when the RSI enters the overbought zone and sell when it enters the oversold. In many cases this is profitable, especially if someone takes into account other technical criteria. Below there are two daily charts in which the inverse use of RSI would have produced very profitable trades. Notice that the upward breaking of the 70 line is accompanied by a breakout and a gap.
Inverse use of RSI in AAPL
Inverse use of RSI in EMC
Conclusively, RSI is a very subjective oscillator (like most of the indices and oscillators) and the signals it produces depend mostly on the preferences and interpretation of the technical analyst. It is only a supplementary secondary criterion and its use is not at all a prerequisite in successful trading decisions.