Relative Strength Index (RSI) – Why RSI Divergence, Overbought, & Oversold Conditions Fail Terribly?

Updated: a day ago

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 the markets.


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, and traditionally people consider that the stock is in an overbought situation 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 the trades:

  1. Bullish and Bearish Divergences

  2. 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



Image 1 – JSW Steel chart showing 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



Image 2 – Nifty chart showing RSI Bullish Divergence

When the price makes a lower low, and when RSI makes a higher low, this condition is recognized as Bullish Divergence. It is advisable to take Long trades (or close if you are carrying Short positions) at this moment.

RSI Overbought and Oversold

Image 3 – Bank Nifty showing Overbought condition

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.


Image 4 – Reliance showing Oversold 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.


Let me explain in detail.

Failure of RSI Overbought


Image 5 – HDFC showing Failure of Overbought condition

When the price is showing a strong move on the upside, RSI can stay above 70 for a longer duration. If you take a SHORT trade at this condition, the price will hit your Stop Loss many times as you are taking trades against the strong trend.


If you look at image-5, RSI stayed above 70 for more time when the price is giving a strong move in the upside direction.

Failure of RSI Oversold


Image 6 – ITC showing Failure of Oversold condition

When the price shows a strong move on the downside, RSI can stay below 30 for a longer duration. If you take a LONG trade at this condition, the price will hit your Stop Loss a few times as you are taking trades against the strong downtrend.


If you look at image-6, RSI stays below 30 for more time when the price gives a strong move in the downward direction.

Failure of RSI Bearish Divergence

RSI Bearish Divergence can occur continuously in an uptrend, and taking Short trades is against the trend.


Even if you can catch the top, you may not be able to make big money as sitting with the position is also a challenging task for most retail traders.


Image 7 – Bajaj Finance showing Failure of RSI Bearish Divergence

If you look at the image-7, RSI bearish divergence failed many times in uptrend. In fact, the occurrences of many bearish divergences indicate a strong uptrend. Isn’t it?

Failure of RSI Bullish Divergence

RSI Bullish Divergence can occur continuously in a downtrend and taking long trades at this point is against the trend.


Image 8 – RCOM showing Failure of RSI Bullish Divergence

If you look at image-8, RSI bullish divergence failed many times in a downtrend.


In fact, the occurrences of many bullish divergences indicate a strong downtrend. Isn’t it?

RSI Hidden Divergences

RSI Hidden divergences (Bullish and Bearish) are the best way to make trades because of the below reasons:

- Trades will be in the direction of the trend

- Success ratio is better as compared to conventional RSI divergence

- Good Risk-Reward as a trend can continue at higher levels.

RSI hidden divergences are first proposed by Andrew Cardwell and John Hayden. In the book “RSI – The Complete Guide,” John Hayden has explained these hidden divergences in detail.

Image 9 – RSI Hidden Divergences

The above image shows the formation of both Hidden Bullish and Hidden Bearish Divergences.


We can see some charts which show these hidden divergences, and we will also see the results.


RSI Hidden Bullish Divergence


Image 10 – Amazon showing RSI Hidden Bullish Divergence
Image 11 – Facebook showing RSI Hidden Bullish Divergence
Image 12 – Microsoft showing RSI Hidden Bullish Divergence

If you look at the image-10, image-11, and image-12, the price is on the uptrend.


It showed an RSI hidden bullish divergence (Price makes a higher low, whereas RSI makes a lower low) and proves that it was a fantastic opportunity to take a long trade as the price rallied upward.

RSI Hidden Bearish Divergence

Image 13 – Coca-Cola showing RSI Hidden Bearish Divergence
Image 14 – TESLA showing RSI Hidden Bearish Divergence
Image 15 – USDJPY showing RSI Hidden Bearish Divergence

If you look at the image-13, image-14, and image-15, the price is in a downtrend.


It showed an RSI hidden bearish divergence (Price makes a lower high, whereas RSI makes a higher high), and it proves that it was a fantastic opportunity to take a short trade as the price rallied in the south direction.

Conclusion

As the name suggests, any indicator gives an indication of the price, and they don't dictate the price. RSI is not an exception. Changes in the price will bring the movements in RSI levels and not vice versa.


Indicators are definitely helpful for beginners and algo traders. For beginners, indicators help avoid unnecessary trades, and for algo traders, they help develop a system.


However, a trader must get mastery of price action trading if he wants to grow in his trading career.


Ultimately, PRICE IS GOD. Isn't it?






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© 2020 by Indrazith Shantharaj.