Use RSI More Effectively

In the last couple of weeks, we had discussed the MACD indicator and also talked about the Hook-Up pattern. Taking this series forward, the Relative Strength Index or RSI would be the topic of discussion for the next few weeks.  RSI is a one of the most popular indicators used by technical analyst.

We shall delve into how to the use this indicator more effectively but would not discuss the formula or construct of the indicator. There are lots of free literature available online that explains the formula. Hence, let us focus on how to use this indicator more effectively.

The default setting for the RSI is 14 period. In a daily chart, the setting would be 14-days and in weekly chart, it would be 14-weeks, am sure you get the logic. The indicator is designed in a such a way that its oscillates between 0-100. Irrespective of how strong the underlying trend is, the RSI indicator will not exceed the extreme values of zero or hundred and will be confined within this boundary.

The RSI indicator is most commonly used as a tool to identify how overbought or oversold the markets are. The default setting for the overbought / oversold reading is set at 30 & 70. A RSI reading of 30 or below would indicate that the markets are oversold; a reading of 70 or above is typically considered as an overbought territory.

Similar to any other indicator, the RSI too should be used in conjunction with the underlying trend in the price. So, use the RSI to hunt for buying opportunities in an uptrend and selling opportunities in a downtrend. In a strong uptrend, the RSI tends to remain at or above the 70-mark for a prolonged period of time. And, in a strong downtrend, the RSI would be near or below the 30-mark.

What is the logical interpretation of an overbought reading in a strong uptrend? A RSI reading of above 70 is a warning that price is stretched to the upside and could get into a correction or consolidation. Hence, it makes sense to defer the decision to buy the stock and await a correction or consolidation before buying. It does not mean that one should sell the stock or initiate short positions. 

As highlighted above,  use the technical indicators, including the RSI, to identify buying opportunities in an uptrend and selling opportunities in a downtrend. Hence, in a strong uptrend, do not use the RSI to look for shorting opportunities as this would mean you are acting against the trend. Wait for the RSI to get to normal levels and look for buying opportunities instead.

Have a look at the daily chart of Alembic Pharma featured below. The price has been in a steady uptrend and notice how the 14-day RSI (plotted below the price action) has tended to stay near or above the 70-mark for best part of the uptrend. Also notice how the price has tended to consolidate or get into a counter trend correction whenever the RSI reached extreme values above the 70-mark.

It is apparent from the above chart, an overbought reading within a strong uptrend is not a sign to go short. If you are already holding the stock, it may be a viewed as a warning to snug your stop loss closer to the price action. If you are looking to buy the stock, an overbought RSI reading should serve as an alert to postpone the buying decision and await a correction for better entry levels.

Next week, we will take the RSI discussion forward and talk at length about the behavior of RSI in a strong trending market. We will also highlight a few methods to initiate trades using the RSI.