Stock Market Series -2 - The Relative Strength Index (RSI) Secrets: Important Facts- Part-1

'I haven't found anything in over thirty years of work that can hold a candle to what RSI can do.' - Andrew Cardwell 

'I've always used three keys to success I talk to people about when I give a presentation — methodology, patience, and discipline. The discipline to follow your rules, stay within your rules, control your emotions; and the patience to, as I quote, say allow the market to show you what it wants to do, not what you want it to do. Well, a lot of people force the issue. Nobody holds a gun to my head to tell me what to trade.' - Andrew Cardwell 

'RSI is perhaps the most popular of all technical oscillators, in that it provides an easy-to interpret indication of possible market turning points and trend strength.'- Matthew Clements, editor of The Technical Analyst magazine  

'The RSI indicator is a cruel mistress! She lures us in with promises of easy money and trading success, only to drain your trading account balance in a run of terrible stop-loss strikes, even though the indicator said BUY! The RSI indicator is usually the go to oscillator for the novice trader when deciding to enter that first trade. There is a simple, valid reason for this: The RSI indicator is simple to read and understand.' - Humbletraders.com 

'RSI measures momentum – momentum is perhaps the most important factor in trading. If you understand momentum, you are 90% of the way home.' -Paul Dean 

'The trend is your friend UNLESS it is about to end.' -Thomas DeMark

Introduction: Why RSI is so Magical?

These are some of the most important things RSI can tell us or warn us:

1. Whether the price is likely to go up or down (momentum).
2. Through divergences, when a trend is beginning to change (slowdown of momentum).
3. Trend continuation signals through positive and negative reversals (Andrew Cardwell's brainchildren).
4. Set price objectives for negative and positive reversals (Andrew Cardwell's discovery)
5. Whether a breakout is going to happen in a channel or a pattern (Leading Indicator)
6. When to buy and When to sell (Only Purpose for which Wilder invented it)
7. A list of good buying options too.

For succeeding in stock market, we need to know just three things:

1. What to buy?

2. When to buy?

3. When to sell?

RSI can tell us all above three things and more!

1. The Hidden Challenges of RSI Trading

There are certain challenges, due to which RSI may perhaps be the most complex indicator in the whole stock market universe. Most of us use indicators without knowing their secrets.

For example, many of us don't know how RSI is calculated, why it gives divergences and why it is called a leading indicator.

We find one or two tricks by reading or by chance and consider ourselves masters of RSI or any other oscillator. We don't take the trouble of digging deep in one indicator, but keep on switching indicators in search of the magical indicator.

Just remember, by digging 100 shallow holes, you can't succeed in digging a well. If you wish to dig a well, keep on digging at one place. And if you are going to dig deep in stock market, let that place be RSI. If we dig deep, perhaps we may strike gold!

Pitfalls or Challenges which a RSI trader usually faces, about which we may be blissfully unaware:

Lack of RSI Studies in the Indian Context

Acquiring in-depth knowledge about RSI or any other indicator is pretty difficult. For it we need the help of good books, lot of exclusive practice and a thorough discussion of the indicator's successes or failures in the Indian context. We trade in Indian stock market with the rules, which were written for U.S. markets.

Unfortunately, most of Indian websites and Indian books contain copy-paste material of foreign websites or books. We seriously lack native study material. What works in American market, may not necessarily work in Indian market. 

Challenge of the Timeframe

Most of the problems occur and most of the signals fail, just because we apply RSI strategy of one timeframe to another timeframe. 

What works in a daily chart may not work in a weekly chart and vice versa. Perhaps this is why we see a lot of conflicting opinions regarding RSI. 

Therefore, the tricks of RSI which work in one timeframe may or may not work in another timeframe.

Wilder invented RSI for daily chart!   Andrew Cardwell preferred weekly charts!

Challenge of the RSI Period

To add to the confusion, RSI can be set to different periods, which may give very different results.

Wilder had set a period of 14 days for his daily chart.

But in order to get more signals, day traders tamper with this setting and use a shorter period like 9 periods or 3 periods. Long-term investors use settings for a longer period, like 21 periods or so. So neither their experiences nor their findings will be much useful for conventional investors, unless they trade by modifying the RSI periods.

Target Markets are Different

There are several markets in the world. Whatever has been written for Forex Traders (like Paul Dean's books) may not be useful for a stock market trader, because movements in a Forex market are on a smaller level, so a gain or loss of 1 dollar in price is seen as heavy gain or loss. Likewise, RSI strategies of commodity traders, bond traders or like may not succeed in stock markets. When target markets are different, successful strategies are apt to be different as well. What succeeds in one market, may not necessarily succeed in another.

RSI Readings Differ on Different Softwares/Websites

There are several stock market blogs and facebook groups, in which traders post their findings on RSI, but I found to my dismay that these are not always reliable. The simple reason is that due to smoothening or data length mismatch, RSI readings are different on different websites or charting softwares. So when you are talking about bearish divergence on RSI, it may turn out that in reality there was no bearish divergence as such and due to the wrong RSI reading in your software, you thought there was a divergence, when there was none. Most people love free softwares and tools. But their RSI readings do not match. 

Important: RSI readings are different on different softwares, so be cautious. Whenever you make a trade on the basis of RSI readings, make sure that you are trading on the correct readings as given on Investing.com.

Terminology Clutter

In the RSI world, there is so much confusion regarding price/ RSI divergence due to its so many variations, most of them quite unnecessary and repetitive. There are bullish RSI divergence, bearish RSI divergence, positive RSI divergence, negative RSI divergence, positive reversal, negative reversal, regular RSI divergence, classical RSI divergence, hidden bullish divergence, hidden bearish divergence etc. 

Looks like every expert comes in and give a new name to RSI patterns.

Let us know how RSI was invented and for what purpose?

2. Birth and Growth of RSI

RSI was invented by J. Welles Wilder and he described it in his book 'New Concepts in Technical Trading Systems' in 1978.

What is RSI?

RSI is a momentum oscillator, measured on a scale from 0 to 100.

On this scale from 0 to 100, high and low levels are marked at 70 and 30, which respectively show overbought and oversold levels.

The default period for RSI is 14 day in a daily chart.

The Lines and Zones on RSI Panel

You will find price action on the top panel, while RSI is in the bottom panel.

The shaded area from 30 to 70 shows the normal range of RSI, where it is neither overbought nor oversold.

RSI is considered oversold below 30 and overbought above 70.

There is a Centre Line at 50 level, which is the exact centre of RSI scale (from 0-100) as well as its normal range (from 30-70).

When RSI line crosses above 70 ( overbought level). Then it slides down to 30 (oversold level) and penetrates it. Then it pushes up and touches the Centre Line, and then it breaks the Centre Line. One can find this pattern in every chart.

You will need all this to remember, as it will be handy when we will discuss RSI signals, patterns and strategies.

Why Was RSI Invented?

J. Welles Wilder is an American mechanical engineer, turned technical analyst, best known for his work in technical analysis.

Wilder is the father of several technical indicators that are now considered to be core indicators in technical analysis software. These include Average True Range , the Relative Strength Index (RSI), Average Directional Index , and the Parabolic SAR .

Wilder wanted to find out the right timing for his trades: when to buy and when to sell. He wanted to find an indicator, which can give sufficiently reliable buy and sell signals for a stock or commodity. And for this, he wanted to detect oversold and overbought levels of a stock.

For giving more weightage to the recent price move, Wilder uses Exponential Moving Average for calculating RSI. This is why RSI is more smooth and consistent than other indicators.

While using RSI, never forget that its primary function is to tell us when we should buy a stock! And when we should sell it! This is the chief purpose, for which it was invented.

RSI Is a Leading Indicator

Wilder said about RSI, “It measure(d) the current strength and weakness of a particular market often in advance of the move."

RSI is the strength metre of a stock/index and it is considered a leading indicator.

There are two types of indicators in stock market: lagging indicators and leading indicators.

Lagging indicators follow price (like moving averages).

Leading indicators lead prices, that is, price follows them (like RSI). Therefore, the movements of RSI can predict what the price is planning to do. 

RSI shows the strength of a stock or index relative to the historical strength of the same stock.

The calculation method is the soul of RSI, so we are going to spend some time here. We will tamper with prices to check how RSI moves and reacts the way it does. Why we find RSI divergences, why it is considered overbought above 70 or why it is considered oversold below 30.