The relative strength index (RSI) is a technical momentum indicator that compares recent price gains against recent price losses. It is primarily employed by traders and analysts to indicate possible overbought or oversold conditions in a market. However, overbought and oversold assets do not necessarily turn around right away. That means it is beneficial to get confirmation from another trade signal before acting on RSI.
Key Takeaways
- The MACD can confirm that it is time to buy or sell when RSI indicates a security is oversold or overbought.
- Moving average crossovers can also help RSI users to pinpoint the right time to make a trade.
- Smoothed RSI applies the moving average procedure to RSI itself, making the indicator less twitchy and leading to fewer false positives.
- Long-term RSI uses RSI on a longer time scale, such as weeks or months, to identify a larger trend and ensure that short-term RSI trades are going in the right direction.
- RSI can also help identify uptrends and downtrends for use with Jessie Livermore's pivotal point system.
How Does the RSI Work?
RSI readings range from zero to 100, with readings above 70 generally interpreted as indicating overbought conditions and readings below 30 indicating oversold conditions. Since the RSI measures the magnitude of recent price movements, it is prone to generating false signals following sudden, sizable price changes.
Generally, as an asset's price rises, the RSI will rise as well because average gains will outstrip average losses. When the asset price falls, losses typically outstrip gains, causing the indicator to fall.
Calculating RSI is usually very time-consuming. However, RSI is popular enough that charting websites and software programs will frequently do all the math and create easy-to-interpret graphs.
Moving Average Convergence Divergence (MACD)
One technical indicator that can be used in conjunction with the RSI and helps confirm the validity of RSI indications is another widely-used momentum indicator, the moving average convergence divergence (MACD). This indicator calculates momentum differently from the RSI by comparing the relative positions of a short- and long-term moving average.
Traders primarily monitor the MACD for signs of momentum diverging from price. While the price may continue to move up, with the RSI maintaining overbought readings for quite some time, the MACD shows divergence by beginning to turn down as the price continues to advance. That provides an additional indication confirming that a market may be reaching a level where it is overextended and, therefore, likely to retrace soon.
The MACD and RSI are both contrarians by design. They go against popular opinion by signaling to buy when there is a lot of selling and signaling to sell when there is significant buying. When both indicate buying, then the security is more likely to be genuinely oversold. Similarly, the security is probably overbought and headed downward when both RSI and MACD generate sell signals.
Moving Average Crossovers
Moving average crossovers can also be used to confirm RSI indications that a market is overbought or oversold. RSI is often used to obtain an early sign of possible trend changes. Therefore, adding exponential moving averages (EMAs) that respond more quickly to recent price changes can help.
Relatively short-term moving average crossovers, such as the 5 EMA crossing over the 10 EMA, are best suited to complement RSI. The 5 EMA crossing from above to below the 10 EMA confirms the RSI's indication of overbought conditions and possible trend reversal. Conversely, an upside crossover provides an additional indication that a market might be oversold.
Smoothed RSI
It is also possible to apply the EMA process to the RSI itself to obtain the smoothed RSI indicator. The smoothed RSI is much less twitchy than the RSI indicator, leading to far fewer false positives and better-defined trends. On the other hand, smoothing RSI with an EMA also makes RSI slower to respond to genuine changes because all EMAs add lagged variables.
Long-Term RSI
Although traders generally use RSI on smaller time scales, it can be used with weeks or even months as inputs instead of days, hours, or minutes. By using a longer time scale, it is possible to align short-term trades with long-term trends. If the monthly RSI is still reasonably low and rising, then a daily RSI buy signal is more likely to succeed.
Similarly, a high and declining monthly RSI suggests that a daily RSI buy sign is probably a false positive. Finally, a daily RSI-buy signal could mark the beginning of a new bull market if the monthly RSI is very low and declining.
Livermore's Pivotal Points
RSI can also be combined with legendary trader Jessie Livermore's pivotal points system, which should not be confused with pivot points. There has been a lot written on pivotal points. However, the basic idea is that if a security makes a low and then makes a second lower low, the first low becomes a pivotal point. If the security's price rises above that pivotal point, the downtrend has ended, and it might be time to buy.
What gives many traders trouble with Livermore's system is figuring out when a downtrend has gone far enough for pivotal points to work. RSI, with its clean zero to one hundred range, makes this easy. When RSI is below 30 and a bullish reversal pivotal point occurs, a buy is more likely to produce profits than when either of these signals occurs alone.
As is well-known, Livermore liked playing the bear-side better, so it is possible to reverse the procedure for selling and shorting. When a security makes a high followed by a second higher high, then the first high becomes a bearish reversal pivotal point. Suppose the security's price falls below that pivotal point, and RSI is still above 70. In that case, it is probably time to sell the security and maybe time to sell it short. Furthermore, Livermore's pivotal points can also be used with smoothed RSI for better-defined uptrends and downtrends.
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