Relative Strength Index (RSI) – Why RSI Divergence, Overbought, & Oversold Conditions Fail Terribly?
Updated: Dec 13, 2022
When it comes to stock market trading, there are two schools of thought. One is Fundamental Analysis, and the other one is Technical Analysis.
Fundamentalists are more concerned about the company's management, various products, Sales, Price to earnings ratio, ROE, Cash flow, Debt to equity ratio, Competition, etc. However, Technical analysts merely consider the analysis of past behavior of prices to interpret their study.
Any person who wants to learn technical analysis will be introduced to two indicators at the beginning – Moving Average (MA) and Relative Strength Index (RSI).
This article will deal with why the traditional RSI strategy does not work and provides an alternative method that gives excellent results in all markets.
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What is RSI Indicator in the stock market?
The relative strength index (RSI) is a momentum oscillator used that measures the magnitude (both speed and change) of recent price changes.
J. Welles Wilder developed it, and it was first time introduced in the book "New Concepts in Technical Trading Systems" in 1978.
The RSI oscillates between zero and 100, people consider that the stock is overbought when the RSI is above 70 and oversold when RSI is below 30. Many systems generate trading ideas by looking for divergences and failure swings.
Below are the two traditional characteristics of RSI which are used by many Traders to take trades:
Bullish and Bearish Divergences
Overbought and Oversold conditions (30 and 70 rule)
How RSI is calculated - RSI formula
The basic formula for RSI is below:
RSI = 100 – [100 / ( 1 + (Average gain / Average loss ) ) ]
The average gain or loss used in the above formula is the average percentage gain or loss during a look-back period.
RSI uses 14 days as the standard period to calculate its value. Anyone can change these settings.
What is RSI Divergence
There are two types of divergences:
1. RSI Bearish Divergence
2. RSI Bullish Divergence
RSI Bearish Divergence
As per traditional definition, when the price makes Higher High and RSI makes Lower High, this condition is recognized as Bearish Divergence, and it is good to take Short trades (or exit if you are holding Long positions) at this point.
RSI Bullish Divergence
When the price makes a lower low and when RSI makes a higher low, this condition is recognized as a Bullish Divergence. It is advisable to take Long trades (or close if you are carrying Short positions) at this moment.
RSI Overbought and Oversold
As per traditional definition, any RSI movement above 70 is considered an Overbought condition. Hence, it is advisable to exit your old long positions or look for SHORT trades when the script is in Overbought condition.
As per RSI's old definition, any RSI movement below 30 is considered an Oversold condition. Hence, it is advisable to exit your old short positions (if any) and look for Long trades when the script is in Oversold condition.
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Why it is a Bad Idea to Use Traditional RSI Divergences and Overbought/Oversold conditions?
If you use the above-mentioned RSI traditional concepts as it is, then there is a higher probability of poor trading results.
Because these concepts always suggest taking the trades against the trend and attempting to catch the Tops and Bottoms.