How Traders Put the RSI to Work

Recently, a reader wrote in a good question about the RSI and my decision-making process. I thought it would be worth sharing with everyone.

Read on below to see what I said…

Hi Larry, your chart discussions are very interesting. When looking at RSIs in my own account, I noticed that the current RSI indications can depend enormously on the time span selected. An RSI indication at “overbought” can even change to near “oversold” just by changing the time span on the chart.

Sure, I should not be surprised about that because it’s mathematics and the amount of data that goes into it depends on the chosen time span. But it raises the question as to which time span one should be looking at. I noticed you often discuss RSI on 9- or perhaps 6-month time spans.

Is that the right time span to gauge a trend – even a short-term trend? It would be interesting to learn how you view and use those time spans in your decision-making process.

– Urs G.

Hi Urs, thanks for writing in with your question.

Traders use the RSI because it helps gauge a stock’s momentum. This is important in identifying the strength (or weakness) of any move.

They want to avoid buying into an up move just as momentum is drying up, for example.

Beyond that, though, the RSI helps identify when a stock is vulnerable to a reversal – that is, when a stock is overbought or oversold.

The RSI takes the size of the average up move over a number of days (typically 14). It then divides it by the average size of the down moves over the same time.

The RSI then converts those calculations into a number between 0 and 100 – below 30 typically means a stock is oversold while above 70 means it is overbought.

You can see an example of how it works in the chart of Energy Select Sector SPDR Fund (XLE) below…

Energy Select Sector SPDR Fund (XLE)

Source: eSignal

When the RSI (bottom half of the chart) goes into overbought territory (red circles) on or near the upper grey dashed line and then rebounds lower, XLE has topped out and retraces lower.

And when the RSI has gone into oversold territory (green circles) at or near the lower grey dashed line and rebounds higher, XLE has bottomed out and starts to rally.

While it’s not always an exact science, this shows why traders can find it so useful…

They can exit trades when momentum is starting to dry up. They can also use a reversal in momentum to enter a new trade.

For example, a trader may do a short trade when the RSI reverses out of overbought territory (red circle).

And by adjusting the settings, they can tailor the RSI to their needs…

Adjusting the Settings

The default setting for the RSI is typically 14 “time periods.” Meaning, if you use a day chart, it represents the last 14 days of data. Or with a weekly price chart, it uses 14 weeks of data.

That’s why you’ll often get a different reading when you switch between different time periods like a daily chart vs. a weekly chart.

It’s important to note that the RSI’s calculation doesn’t change no matter how far you go back in time – say, six or nine months. As a default, it always uses the last 14 time periods.

To avoid any confusion, it’s often best to pick just one time period (e.g., a day chart) and stick with it. That way, you’ll enter and exit trades with the RSI calculated from just one set of price data.

So, for example, a trader planning to hold a position anywhere from a couple of days to a couple of weeks may use a daily chart.

Yet someone who trades over a shorter timeframe might use an hourly chart. It’s often a good idea to use a chart that best reflects the time you’re likely to hold the trade.

And then as you get more advanced with your trading, you can adjust and customize the RSI’s parameters to best suit your needs.

If you’re trading something volatile like a commodity or crypto, you can increase the RSI time periods higher – from 14 to 20, for example.

Because it averages out those moves over a longer period, it can take some of the volatility out of the RSI. And that means it’ll throw up fewer false overbought and oversold signals.

Traders can also adjust the overbought and oversold levels. Some traders might use 80/20 instead of the standard 70/30 levels. Again, the aim is to reduce false signals.

The key is to test out any combination on the chart to see what works best for the product you’re trading and your preferred time frame.

Thanks again, Urs, for your question.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict