The Relative Strength Index, or RSI, is a popular momentum indicator used throughout the field of TA.
Rather than get into the definition and construction of this indicator, I think it’d be more helpful to go into how I personally use the indicator. If you need a refresher or are new to this topic, I suggest heading over to stockcharts chart school to familiarize yourself with it.
First off, I use a 14 period RSI for all the timeframes I look at because markets are fractcal, meaning that repeating patterns occur at all scales / timeframes.
The two main ways I use RSI are as follows:
1. Determining Bull / Bear Ranges
2. Identifying Divergences
Determining Momentum Ranges: If I can help it, I want to be trading in the direction that momentum is leaning. So how exactly do I define a bull or bear range? Well, it’s slightly subjective but anytime something hits overbought or oversold conditions and does not reach the opposite extreme on price consolidations or pullbacks I think of it as being bullish or bearish based on the original confirmation above 70 or below 30.
Bullish Range Example: When momentum is consistently hitting overbought, without reaching oversold.
As we can see from the chart above, after momentum transitioned into a bullish range by hitting overbought conditions in July 2013, AAPL continued higher in a nice uptrend. Since momentum never hit oversold conditions on pullbacks, that weakness ended up being a buying opportunity rather than a reason to be concerned if long or trying to be short.
Bearish Range Example: When momentum is consistently hitting oversold, without reaching overbought.
As we can see from the above chart, KOL has had momentum in a bearish range for at least the past two years, hitting oversold conditions on each selloff and failing to reach overbought conditions on relief rallies and consolidations. This behavior by momentum was signaling to me that trading in the direction of the underlying downtrend was still the way to go and that strength should be sold, not bought.
Mixed Range: When momentum is hitting both overbought and oversold conditions frequently.
Sometimes, especially in trendless markets like MOO, momentum will not be of much help because it hits overbought and oversold conditions every couple of months. This makes it difficult to gague what’s actually occuring, though in this case it’s nothing. I generally like to stay away from markets with RSI readings that look like this until price action improves and we get a more decisive move in one direction or the other.
Overall, I think that simple clues like noticing what range RSI is in can be a big help in determining if you’re trading in the direction of the underlying trend or if a stock is undergoing a change of character.
Divergences: When looking at momentum, I want it to confirm price by making new highs / lows in tandem with price. If it’s not, that could be the early signs of a deterioration in the trend and gives me a heads up to protect profits if currently involved or be on the lookout for a counter trend trade.
Bullish Divergence: When momentum fails to confirm new lows in price.
In the case of Coffee futures, prices were in a downtrend for months, but as they approached an important support level and tested it multiple times in March, momentum diverged positively. To me this says, if I’m short, I probably want to be covering some here as the r/r is no longer in my favor. As a potential long looking to play a counter trend rally, this gave me a signal that something has changed and here might be a good place to try that counter trend trade. Waiting for this divergence allows me to clearly define my risk when trading against the trend, rather than blindly bottom fishing. Ultimately, we got a little counter-trend rally, but small clues from momentum are often instrumental in being able to maneuver these types of situations better regardless of which side I’m approaching it from.
Bearish Divergence: When momentum fails to confirm new highs in price.
In the case of XLU, prices made new highs in late January, but momentum failed to confirm those highs and prices have since sold off sharply from those levels. Again, if long this divergence would tell me to be a little more cautious as chances of a false breakout or other price reversal are much higher now. If I was looking for a counter-trend short, the divergence confirmed with prices breaking back below the early January highs and provided a short entry where risk is clearly defined, rather than trying to blindly fight an uptrend.
Ultimately, I use divergences to help determine when an underlying trend might be at risk of changing. With that information I can then be on alert to pay attention to price action more closely to protects profits in my trade if I’ve been riding the trend or find an entry for a counter-trend move.
At the end of the day, RSI, or any indicator for that matter, is not the end all be all and is secondary to price action. That being said, it is an important tool that I think can be helpful for market participants to improve their edge and identify opportunities throughout global markets.
As always, if you have any questions feel free to reach out and I’ll get back to you as soon as I can.