Using RSI Technical Indicator

Do you believe in technical analysis? I do. I don't take it quite as seriously as some people, but I recognize that I almost always trade better when I spend at least a few minutes evaluating the technicals.

Algorithms and trade desks use technical analysis, so at the very least, identifying where other traders might see a trend is enough to help you take advantage of the actions they are likely to take.

In this post, we will discuss the relative strength index, or RSI. It is one of 3 technical indicators I take seriously, the other 2 being MACD and Moving Averages. There are a handful of candlestick patterns I also take seriously.

What is RSI and what is it used for?

The Relative Strength Index, or RSI, is a measurement of momentum in a stock's price action. When a stock's price is bouncing all over the place, it can be difficult to measure momentum on candlesticks alone. Likewise, when a stock is rocketing higher or tanking down, it can be difficult to determine when that trend is starting to lose momentum. RSI clears the picture for us.

RSI is designed to measure how strong a stock's price moves are. Specifically, it measures how extreme its positive days are relative its negative days. If the stock gains an average of 1% on green days, but loses an average 1.2% on down days, then the trend is negative. However, this comparison is difficult to identify on a candlestick chart. RSI again clears the picture.

Always keep in mind that RSI is not a lagging indicator (gives a clear picture of the past), but rather a leading indicator (predicts the future). It is common to see the information derived from RSI to take a few weeks to play out. Options trades off RSI should have at least 4 weeks to expiration.

From late Feb to late Mar, AAPL price action was congested. But RSI gave a clear indication there was momentum to the high side.

RSI is measured over time between 1 and 100. A reading of 100 indicates extreme bullish momentum, and a reading of 1 indicates extreme bearish momentum. It is exceedingly rare to find RSI at those extremes. Readings between 80 and 20 are more common because buyers and sellers start taking profits when the stock moves dramatically in their favor.

Nevertheless, we can use RSI to give us a picture of momentum, so we can hitch a ride on the trend, or so we can identify when momentum is tapering and we are likely to see a reversal.

The 3 ways to use RSI

In general, we can use RSI in 3 ways. 

1) To measure overhype or capitulation indicating unsustainable price action;
2) To measure momentum tapering off and probably reversing; and
3) To observe divergence to see if traders showed conviction by rejecting extreme prices.

We will go through each of these methods. They each have different strengths and weaknesses that can help improve your analysis.

1) Measuring overhype or capitulation: When stocks move very rapidly in one direction, then it may become overbought or oversold. Traders are emotional people, and both FOMO and fear are powerful motivators. This can lead to unsustainable buying frenzies or selloffs that are liable to lose steam and reverse.

RSI is measured on a scale from 1-100. During a buying frenzy, the RSI reading can break 70. 70+ is generally regarded as overbought. This indicates that momentum to the upside is extreme, which may mean that the rally is unsustainable. With such excessive buying, buyers may become exhausted and shareholders may be enticed to ditch shares for large gains.

On the other hand, readings below 30 indicate extreme bearish sentiment and may indicate that shareholders are capitulating.  With prices dropping rapidly, buyers will be enticed to pick up shares on the cheap. This will provide support and end the rapid drop.

Notice that I put the word may in italics. If prices are rising or falling extremely rapidly, the trader must try to determine why. Is a huge rally justified by good news? Does it make sense for the share price to be rallying to levels that would previously be considered overbought (perhaps there was a positive earnings report)? Or does it seem to be an odd rally with no real backing? 

Depending on what is driving the rally, stocks can stay overbought for a long time before the momentum fades. This was evident with TSLA began flying on reports it swung to a sustainable profit. It changed the thesis on TSLA, thus opening the door for a long term rally that would have previously been considered unsustainable and unwarranted.

Be careful when using RSI to measure overbought/oversold conditions. Since rallies and selloffs can be sustained for a while, it is not wise to immediately try to inverse the market when 70 or 30 gets hit. This is my least favorite use of RSI because there are many reasons why a stock could moon or tank. I prefer to use the 70/30 measurement in conjunction with other indicators.

In late Jan, AMC was overbought and the price soon after dropped. To be fair, this was also forced by most brokers preventing buys. In late May, AMC was again overbought and it appeared momentum would taper off, this time without any barriers to buying.

In early May, PTON was oversold. Sellers were unable to keep pressure on as buyers came back in to scoop shares at lower prices.

2) Measuring loss of momentum and reversal: Continuing off the previous use of RSI, was the market overzealous or overly fearful? Is that momentum beginning to die off, indicating a possible reversal? We can get ahead of this trend and ride it in our favor. This is my preferred use of RSI.

In the prior section, we looked at how the 70/30 measurements show a possible status of overbought or oversold. We also noted how those levels can be sustained for a while, so you don't necessarily want to start buying puts as soon as RSI hits 70. How do we measure the momentum coming off and know when the tide is reversing?

When a stock trades above 70 and then later falls below it, this indicates that buyers are losing strength and the up days are no longer as powerful as they were during the initial upswing. Perhaps buyers are being enticed to sell, putting downward pressure on the stock.

The loss of upward momentum is a good indication that the stock is poised for a reversal. It is uncommon to see a stock drop out of overbought territory and then immediately reclaim it. Instead, it is more common to see a stock lose momentum above the 70 RSI, and then drift downward as profit-takers close their longs and fresh buyers come into the market.

I like to take bearish positions when a stock drops back below 60-65 RSI so I can ensure the loss of momentum is complete. I then look to close the position for a gain when RSI gets down to about 50. The 50 level serves as a key point. If RSI stays above 50, then long-term momentum to the upside is likely to continue following the pullback off of overbought conditions. Taking profits on a bearish play when RSI gets close to 50 prevents me from getting whipsawed if the uptrend continues.

I like to take bullish positions when a stock comes back up from under 30 RSI and appears to be hooking back toward 50. Just as the bearish positions above, I may take profits when RSI gets to about 50 to ensure the upswing isn't just a temporary recovery during a larger downtrend. I much more often play this bullish side than the above bearish side.

However, if the stock busts through the 50 level in either direction, that is a strong indicator that the previousdirection's momentum is not just tapering off, but rather reversing completely. If the RSI breaks through 50, then it is probably a good time to catch a ride until the stock hits the 70 or 30 level again.

In Jan, TSLA came off overbought prices and RSI continued to drop. This indicates likely weakness ahead. In early May, RSI bounced off the 30 level, indicating downward momentum was likely to abate in favor of bullish pressure. RSI now needs to break above 50 to confirm the uptrend, but MACD looks favorable. We will cover MACD in another post.

3) Identifying price rejections and divergence: This is the most complicated way to use RSI, but potentially the most effective. 

Most people think of RSI as a lagging indicator, showing you what happened in the past. But RSI is actually a leading indicator, showing you what is likely to happen in the future by measuring momentum or sentiment changes among traders. If we notice a divergence between RSI and price, we can use this to predict future price movement.

When a stock makes a higher high, we should expect to see the RSI rise with it. After all, if the stock price is going higher, we want to see the relative strength of the stock increasing as well. If we see RSI and price moving in the same direction, it indicates that traders will sustain the new high. Likewise, the same is true for the negative side. We want to see the RSI drop with the price in order to confirm momentum to the downside.

But what about when this does not happen? What if the RSI does not rise with the stock price? What if the RSI goes down when the stock goes up? This indicates that although the price made a new high, buyers are unable to sustain the momentum necessary to support it, and there is little momentum keeping it up.

This presents an opportunity for us. If we see a stock make a higher high but RSI does not follow it up, then the stock is likely to give back its gains and turn lower. Likewise, if a stock makes a lower low but RSI stays high, the stock will likely recover.

These divergences are powerful indicators. But remember that RSI is a leading indicator, so it will take a few days for the stock's movement to catch up to what the RSI shows.

In early April to early May, SPY made a new high but RSI drifted downward. This indicated that buyers did not have the strength to keep the stock rallying, and as a result, SPY gave back its gains and dropped back to the 50 DMA. We will talk about moving averages in another post. RSI is back above 50, indicating likely positive momentum ahead. Also notice that SPY bounced off the 50 DMA every time it hit it. We will talk about moving averages in another post.

In mid-late May, TSLA made a new low, but RSI stayed relatively flat, and in fact made a slightly higher low. It certainly did not tank with TSLA's share price. This indicates that buyers had increased demand as the price dropped and the selloff would likely reverse. The stock did indeed recover slightly after. RSI must break above 50 to confirm the uptrend, but MACD is favorable. We will cover MACD in another post.

Final Thoughts

- Technical analysis involves a lot of confirmation bias and 20/20 hindsight. Using RSI to look ahead is more difficult than finding past examples. Focus on the basics and don't overthink. If you have a stock rising up out from under 30 RSI and RSI did not make a lower low with the stock, then you have a really good probability of winning to the long side.

- RSI is a leading indicator. If you trade based off RSI, be prepared to hold your position for a few weeks while to stock does its thing. It takes time for momentum to shift. No short-term options! Aim for 30-45 days after a divergence indicator.

- Even with the best set-up, sometimes the stock just doesn't cooperate with your technical analysis. Don't be afraid to cut losers, but trade with conviction. Set up exit rules and stick to them, even if it means taking a loss. 

- When evaluating overbought and oversold conditions, always check for new company information (earnings, news) before entering a position. If a stock if "overbought" according to RSI, there might be a good reason. Perhaps the company experienced great news and its higher price is warranted.