What Does RSI Tell You?
The primary trend of the stock or asset is an important tool in making sure the indicator’s readings are properly understood. For example, well-known market technician Constance Brown, CMT, has promoted the idea that an oversold reading on the RSI in an uptrend is likely much higher than 30%, and an overbought reading on the RSI during a downtrend is much lower than the 70% level.1
As you can see in the following chart, during a downtrend, the RSI would peak near the 50% level rather than 70%, which could be used by investors to more reliably signal bearish conditions. Many investors will apply a horizontal trendline that is between 30% and 70% levels when a strong trend is in place to better identify extremes. Modifying overbought or oversold levels when the price of a stock or asset is in a long-term, horizontal channel is usually unnecessary.
A related concept to using overbought or oversold levels appropriate to the trend is to focus on trading signals and techniques that conform to the trend. In other words, using bullish signals when the price is in a bullish trend and bearish signals when a stock is in a bearish trend will help to avoid the many false alarms the RSI can generate.Example of RSI Divergence.
This indicates rising bullish momentum, and a break above oversold territory could be used to trigger a new long position.
A bearish divergence occurs when the RSI creates an overbought reading followed by a lower high that matches corresponding higher highs on the price.
As you can see in the following chart, a bullish divergence was identified when the RSI formed higher lows as the price formed lower lows. This was a valid signal, but divergences can be rare when a stock is in a stable long-term trend. Using flexible oversold or overbought readings will help identify more potential signals.
Another trading technique examines the RSI’s behavior when it is reemerging from overbought or oversold territory. This signal is called a bullish “swing rejection” and has four parts:
- RSI falls into oversold territory.
- RSI crosses back above 30%.
- RSI forms another dip without crossing back into oversold territory.
- RSI then breaks its most recent high.
As you can see in the following chart, the RSI indicator was oversold, broke up through 30% and formed the rejection low that triggered the signal when it bounced higher. Using the RSI in this way is very similar to drawing trendlines on a price chart.
Like divergences, there is a bearish version of the swing rejection signal that looks like a mirror image of the bullish version. A bearish swing rejection also has four parts:
- RSI rises into overbought territory.
- RSI crosses back below 70%.
- RSI forms another high without crossing back into overbought territory.
- RSI then breaks its most recent low.
The following chart illustrates the bearish swing rejection signal. As with most trading techniques, this signal will be most reliable when it conforms to the prevailing long-term trend. Bearish signals during downward trends are less likely to generate false alarms.
The Difference Between RSI and MACD
The moving average convergence divergence (MACD) is another trend-following momentum indicator that shows the relationship between two moving averages of a security’s price. The MACD is calculated by subtracting the 26-period exponential moving average (EMA) from the 12-period EMA. The result of that calculation is the MACD line.
A nine-day EMA of the MACD called the “signal line,” is then plotted on top of the MACD line, which can function as a trigger for buy and sell signals. Traders may buy the security when the MACD crosses above its signal line and sell, or short, the security when the MACD crosses below the signal line.
The RSI was designed to indicate whether a security is overbought or oversold in relation to recent price levels. The RSI is calculated using average price gains and losses over a given period of time. The default time period is 14 periods with values bounded from 0 to 100.
The MACD measures the relationship between two EMAs, while the RSI measures price change in relation to recent price highs and lows. These two indicators are often used together to provide analysts with a more complete technical picture of a market.
These indicators both measure the momentum of an asset. However, they measure different factors, so they sometimes give contradictory indications. For example, the RSI may show a reading above 70 for a sustained period of time, indicating the security is overextended to the buy side.
At the same time, the MACD could indicate that buying momentum is still increasing for the security. Either indicator may signal an upcoming trend change by showing divergence from price (price continues higher while the indicator turns lower, or vice versa).
Limitations of the RSI
The RSI compares bullish and bearish price momentum and displays the results in an oscillator that can be placed beneath a price chart. Like most technical indicators, its signals are most reliable when they conform to the long-term trend.
True reversal signals are rare and can be difficult to separate from false alarms. A false positive, for example, would be a bullish crossover followed by a sudden decline in a stock. A false negative would be a situation where there is a bearish crossover, yet the stock accelerated suddenly upward.
Since the indicator displays momentum, it can stay overbought or oversold for a long time when an asset has significant momentum in either direction. Therefore, the RSI is most useful in an oscillating market where the asset price is alternating between bullish and bearish movements.