In this
post I thought I should talk a little bit about the Relative Strength Index
(RSI). How it is used traditionally and how I use it. I think there are some
misunderstandings of how it should be used today. The RSI can definitely be a
powerful tool but it also gives many false signals so you better understand how
and when to use it.
I have an
article on Medium about the RSI which is more of an introduction to the
indicator and how it is calculated. If you want to read that first, you can find it here. If not here is a very short summary of what the RSI is.
The RSI is
a momentum oscillator that measures the speed and change of price. It was
developed by J. Welles Wilder in 1978. It is mostly used to find overbought and
oversold conditions, where values above 70 is traditionally considered to be
overbought and values below 30 as oversold.
The formula
for calculating the RSI is:
If you want
an example of the calculation, I suggest you check out the article on Medium.
Let’s start
off with some examples of the RSI. All the charts in this post are courtesy of
Stockcharts.com.
In this Tesla chart we have three instances when the RSI falls below 30, indicating an oversold condition, and every time price changes direction a goes up. Important to note is that price does not always immediately reverse direction. In fact it is rare that it does.
Tesla
 |
| Tesla |
In the last
case, price do reverse immediately and very strongly.
Starbucks
In Starbucks,
we see RSI rising above 70 after the stock gaps up in early November. Again, it
doesn't revers direction immediately, but continues to rise while the RSI stay
above 70. Then it finally starts falling and the RSI also goes below 70.
 |
| Starbucks |
Robinhood
Here is a
good example of when the RSI isn’t working that well. In February 2024,
Robinhood started a very strong uptrend and the RSI climbed above 70. But there
was no reverse in price. Price just kept on going with a little correction
before moving even higher.
 |
| Robinhood Markets |
Examples of Trades
I used to
trade this way. I scanned the markets for RSI overbought and oversold
conditions, although I used the values 20 and 80, to cut out most of the noise.
The downside of this is that I also missed some signals, but there is always a downside
to every upside.
I still look
at these conditions and I actually traded Starbucks on the short side in the
example above. But in my opinion, there are too many false signals with this
method. Instead I started to look for divergencies between the RSI and the
price. That means that they go in opposite directions and that could indicate
that a change in trend is coming. Here is an example of a trade I took in Apple
that turned out to be one really awesome trade.
Apple
 |
| Apple |
In March
and April, there was divergence in Apple. Price made new lows, but the RSI was
rising. When price made new lows only to bonce up again, I entered the trade
with a stop just under the low. It was a great entry, not because what later
happened, but because the risk I took was low with a very short stop.
When price
then made huge gap a few days later I added to my position and added again
after it broke out of a consolidation of a few weeks. I finally closed the entire
position when the stock had a larger sell off at high levels.
The RSI was
at or above the 70 level for about two months, but the stock kept rising. I
good reminder that an indicator is just that, an indicator. It only indicates
what might happen. I never take action on any indicator, only on price.
Ebay
Here is an
example of a trade on the short side that did not go so well. I noticed that
the RSI was falling while price was trading sideways. When the price did drop I
took a short position. The price reversed almost immediately and eventually I
was stopped out with a loss.
 |
| Ebay |
In hindsight,
this was not a good entry because it wasn’t such a clear divergence. While RSI
fell the price when sideways, if price had been rising it would have been a
better case. But sometimes these smaller divergencies work out, as in this
trade in General Motors.
General Motors
 |
| General Motors |
I entered
on the break of the trendline, and I am still in this trade. I wish I would
have had the courage to add to my position on the way up but unfortunately, I didn’t.
The RSI have given several overbought signals but the stock has just kept on
rising.
Final Thoughts
RSI is no
magic formula for success, no indicator is. Some people swear by it while
others hate it. I used less than before but I still look at from time to time.
When it comes to divergencies, I much prefer the MACD indicator.
As with any
trading tool, it is what you make of it. If you find an edge with the RSI then
you should definitely use it. If you want to be a trader then understanding the
most common indicators is part of the curriculum, and the RSI is one of the
most common.
If you want
to know more about the RSI I have put together a few links for you.
- RelativeStrength Index (RSI) Indicator Explained with Formula – Investopedia
- RelativeStrength Index – Wikipedia
- TheRelative Strength Index Revisited – Research Gate (if you really want to nerdin on RSI)
Video from Charles Schwab with an introduction to RSI
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