One of the key technical indicators I use is the Relative Strength Index (RSI).
The reason for that is simple.
The RSI highlights momentum changes that can lead to a stock or index changing direction.
That works well with my mean reversion strategy. This strategy looks for stocks that have overshot in one direction. We aim to profit when they snap back the other way.
And today I’d like to take a fresh look at this indicator. Recently, I received a question from subscriber Tony L., who asked: “Do you use the 14-day default as your setting for RSI in your trading examples?”
The short answer is yes. I do that to keep consistency among all the charts we look at daily.
Today, though, I want to expand on that by showing how you can adjust the RSI to help improve trade setups…
Fine Tuning a Trade Setup
To gauge a stock’s momentum, the RSI uses a calculation based on the number and size of the stock’s average upward moves over a period of time. It then divides that by the number and size of average down moves over the same period.
The RSI converts the result into a number between 0 and 100 and plots that as a line on the chart.
Take a look at the bottom of the chart of the United States Oil Fund (USO) below:
United States Oil Fund (USO)
Source: eSignal
When the RSI is at or below 30 (the lower grey dashed line), the stock is oversold and may have good prospects for a bounce.
You can see this on the USO chart inside the red circles. When the RSI formed a ‘V’ and rallied from oversold territory, USO also bounced.
In the upper half of the RSI, you can see where the opposite applies (orange circle). The RSI tends to reverse from overbought territory (upper grey dashed line), which is at 70 or above on the chart.
In this example, when the RSI made an inverse ‘V’ and rebounded lower, USO also fell.
Yet the RSI has also reversed in both directions even when it is a long way from overbought or oversold territory. We can see this in May through June this year and August to September last year.
If you’ve been studying the RSI for a long time, you can often read these signals without having to adjust the RSI.
However, to help you identify when a stock is oversold or overbought, you can also adjust the RSI’s number of periods on your chart.
This can be helpful with your trade setups.
Below is the same chart of USO adjusted with a seven-day RSI:
United States Oil Fund (USO)
Source: eSignal
Because the RSI is using fewer days with this chart, it is much more sensitive to any changes in the underlying data.
That’s why it has a higher number of bigger swings than the 14-day RSI chart. It has thrown up a lot more oversold signals (red circles) and overbought signals (orange circles) too. By comparison, a 20-day RSI would have fewer overbought and oversold signals than the 14-day RSI.
Although the shorter period RSI provides a lot more potential trade setups, it comes with a catch…
It will also display more false signals. If you blindly react to every potential signal, you could jump into a higher number of trades with a lower probability of success.
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The trick is to experiment with different RSI periods and see which one offers the most reliable trade setup on the stock you’re looking to trade.
Of course, with technical indicators, there are no guarantees.
But by adjusting the RSI even slightly, you might find it greatly improves your chances of success.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
P.S.The RSI is one of the tools we use with our strategy in One Ticker Trader. Each month, we choose just one idea to trade. And we look for the most promising setups in that one theme.
That has helped us achieve an 82% win rate since the service launched last August.
So if you’re looking to improve your trading success, I invite you to check it out. You can discover all the details right here.