RSI: Uncommon approach to a common oscillator

How to use it properly


RSI is a good technical indicator. When used properly it shows dominant market trend and also shows zones for potential local tops in uptrend (bottoms in downtrend) and zones to look for the ends of corrections.

Books say that when RSI(14) is crossing down 70 points line, trader gets a sell signal and when it is crossing up 30 points line a bottom was just formed. This is NOT how regular RSI should be used. In uptrend it will almost never get close to 30 and will frequently go above 70.

If we examine S&P500 daily data from 2009 to 2018 and use RSI(14) the “classic” way we would get 55 sell signals and only 15 buy signals. This is not what one should be getting in very strong bull market. So, in trending markets an adjustment of approximately 10 points should be made. Below there’s chart of S&P500 where RSI(14) dropping below 40 offered a pretty good buying opportunity. And market was overbought only after RSI(14) crossed 80. If we use this logic we will get only 5 sell signals and 68 buy signals.

This is a simple solution to most common mistakes traders make trying to use Relative Strength Index. Additional test can be made to see exactly how many points higher we should put buy/sell thresholds but they would only apply to RSI(14), because shorter and longer period lengths behave way different. More on it later.

How to use RSI
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So most people use RSI(14). Probably not because they like the number, but because they got used to it and they get puzzled by readings from shorter or longer period lengths. But let’s stay with RSI(14) and S&P500 for a while. Chart below shows distribution of RSI(14) readings grouped in pools of a size of 5 points: 0 to 5, 5 to 10, 10 to 15, and so on.


At first we see right skew, that is caused by strong uptrend (we discussed it at the beginning). Another thing is that approximately 35% of all readings fall between 55 and 65. Lastly we get 9% below 40 out of which 1% point is below 30. So again, if we use RSI like we were told to in the books, we would almost never get a buy signal that in a bull market we wait for.

Let’s leave RSI(14) for now, and check out how short and long period RSI behave.

RSI(2):


RSI(30):


The only thing these distributions have in common is skew to the right (uptrend). Besides that there is not much a trader can get out of it. And the worst thing to do is trying to average or compare the readings of short and long term trends visualized by RSI. So coming back to the question why people don’t use different RSI lengths but RSI(14)…? Probably because they don’t see any benefits in doing so, and are so used to normal distribution, that anything different is just too much to handle.

But don’t lose hope! Let’s try to normalize readings of this particular oscillator, so we can apply same logic no matter the period for the calculation. By looking at above distributions we know what needs to be done. RSI(2) distribution needs to be moved towards the center and RSI(30) needs to be moved towards the edges, so we get readings above 70 and below 30.

Let’s see how we did:

RSI(2):


RSI(14):


RSI(30):


There are two main differences between regular RSI and Advantage RSI:

In short period lengths Advantage RSI readings are clustered in the center, but there is still lots of room for oversold/overbought readings in lower (<30) or upper (>70) zone:

How to use RSI
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With longer period lengths, at first glance, we get pretty much same distribution. Or at least so close not to care. They are distributed closer to the center and still have readings in lower/upper zones, but probably no one would even notice it from distribution charts.

What we get though is an ability of Advantage RSI to stay close to 50 line in neutral market, reach 30/70 zones sooner in trending market and to go below 0 or above 100. The last one happens very rarely, but warns trader that extreme market conditions are in place:

trend lines
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There is more trader can do with Advantage RSI than just to wait for it to cross 30/70 line. Since the readings are normalized it can be added, subtracted and averaged. Plus, used to develop more indicators.

If you have any questions or suggestions please contact us.



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