This article fleshes out the mechanisms of the RSI indicator and helps you understand how it ticks.
Once you gain a deeper understanding on how it works, you can analyze its signal more effectively and trade better.
Let’s start.
HOW DOES THE RSI INDICATOR WORK?
The RSI Indicator measures the
Average price of a green candle (gain) for the periods you have set or for the default RSI period (14)
Average price of a red candle (loss) for the periods you have set or for the default RSI period (14)
It then compares the gains versus losses for the set period and plots it as a number value, between 0 and 100, on the charts.
If the gains exceed the losses, RSI will rise for the set period.
If the losses exceed the gains, RSI will fall for the set period.
If the gains are equal to the losses, RSI will straighten for the set period.
If the RSI keeps rising, it implies that the stock is moving up at a scorching pace and therefore can head into overbought territory.
This is why 70 or 80 is regarded as an overbought zone – but this does not hold true for longer period charts, as you will see below.
If the RSI keeps falling, it implies that the stock is crashing at a scorching pace and therefore can head into oversold territory.
This is why 30 or 20 is regarded as an oversold zone – but this does not hold true for longer period charts.
This is something you need to get into your head while analyzing RSI.
The RSI Period Setting
The default RSI period is set to 14.
Here’s what this conveys:
On a 5 minute chart, RSI 14 signals are based on the last 70 minutes.
On a 15 minute chart, RSI 14 signals are based on the last 210 minutes (3.5 hours).
On a 30 minute chart, RSI 14 signals are based on the last 7 hours.
On a 1 Hour chart,RSI 14 signals are based on the last 14 hours
On the daily chart,RSI 14 signals are based on the last 14 days
On a weekly chart,RSI 14 signals are based on the last 14 weeks (3.5 months)
On a monthly chart,RSI 14 signals are based on the last 14 months
What are the logical conclusions we should draw from this:
If the trend is uncertain or hit by global or domestic news andyou are working with shorter periods (1-5 minutes, 15 minutes), you should avoid using RSI until you are confident that it can reliably predict the trend.
This is because if the market is global- or news-based, the candle analysis of the previous day will not hold any significance.
As a thumb rule, you can start using RSI after the day has generated sufficient candles to ensure a reliable signal.
For example, if you are using 5 Minute charts, start using 14 RSI 1 hour into the day. That way, 60 minutes would have passed and you will get a more or less reliable signal.
Here’s yesterday example of Reliance Industries.
If the trend is certain, you can use RSI that takes into account the previous day candles. In other words, in a trending market you can start using RSI from the first candle even for shorter time periods.
Should the 14 Period RSI be religiously followed?
Though many analysts use different periods (some use 7, 9, 10, or 11), the 14 RSI gives fairly reliable signals so long you use it right.
What is more important is this —RSI MUST NOT be used to predict overbought and oversold signals on longer period charts (Weekly, Monthly), as you will find out below.
14 RSI & Different Period Candlestick Periods
Here’re some examples:
RSI 14 works well on daily charts and you can use it to identify momentum or trend for BTST trades. For example:
What about Overbought and Oversold Signals
When RSI crosses above 80 or falls below 20 it does indicate an overbought or oversold state. However, it does not mean that the stock will crash after zooming to 80. For all you know it may move to 85 and stay there for a while, making you lose money – or fall below 20 and get stuck there for a while.
Therefore, if you want to gauge overbought and oversold conditions, use the 20 SMA for double confirmation across all time periods.
Summing up
- RSI 14 becomes an extremely potent indicator when used with 20 SMA
- Traders must focus more on RSI rising or falling instead on focusing on its overbought/oversold levels. This is because the RSI measures the average gain over the average losses for the set period.
- Traders should act only when 20 SMA confirms.
- Traders should analyze RSI 14 to figure out short term trends while reading the monthly and weekly charts.
- BONUS: To latch on to cash stocks with medium term potential, set this screener – Monthly RSI crosses above 50. After getting a list, analyze the fundamentals and act if you wish.
