When I began my journey to learn technical analysis, the relative strength index (RSI) was one of the first indicators I picked up. The reason was simply that everyone was talking about it and I can easily obtain the information on the internet. At one time, I was so naïve that I thought RSI is one of the most important indicators and it is a “must-have” indicator for stock charting. I even assumed that I can easily make money by following the RSI line that bounces between the two lines of limit. The typical two lines of limits are 1) lower limit (30) or oversold, and 2) upper limit (70) or overbought. The idea is to buy when it touches the lower limit (30) and sell when it touches the upper limit (70). The above picture illustrates the buy/sell timing using the RSI line.
During my learning curve, a question popped up in my mind, “If this indicator can make money easily, the person who knew would have exploited it for own advantages. Why would he/she choose to share this precious information?” This question prompted me to think that RSI is not the ultimate solution and technical analysis can’t be so easy. I believe there is no easy way of making money in the stock market. Hence, I decided to conduct a study and I noticed this indicator is risky if you are not cautious. It can misguide you to buy at the wrong trend or sell too early. Let’s examine the examples below.
On the day RSI touches the lower limit (30), it should be a buy for RSI users. However, the Doji breaks the support line and shows a bearish signal. This is not a spring candle due to the low volume. Additionally, the candle on the prior 7 days indicates there is a supply and imminent climatic selling is on the way. The RSI line continues to travel below the lower limit (30) as the climatic sell persists.
The RSI line tested the lower limit (30) twice as the price continues to plummet. Although the RSI line goes up in between the two tests, the price makes little progress due to a lack of demands. After the third test, the climatic sells continue after the RSI bounces from the lower limit. The stock drops 89% eventually.
The price continues to skyrocket after the RSI line touches the overbought limit (70). RSI users would have sold it early thinking it is overbought. They will not buy back even though the stock begins the second stage rally because the RSI line is still travelling at the overbought limit (70). This stock goes up 135% eventually.
The RSI line goes up together with the first rally attempt, then it consolidates at the overbought limit (70) and does not come back to oversold limit (30). This stock goes up another 39% during the RSI consolidation, the total gain is 79% in one month period. If the RSI users sell thinking it is overbought, he/she will miss this handsome opportunity.
RSI can be used to check the current strength of a stock price but not buy/sell. The term oversold and overbought are overly endorsed by some traders, they claim this is an indication of buy/sell. To buy/sell, you need other analysis and rules to guide you. Personally, I do not use RSI for my charting. Too many indicators will give me the wrong impressions of the current trend. I prefer to keep it simple, fast and accurate for my charting.