Trading RSI

I had a query raised by vasanihitesh on http://stockezy.com/opinions/2416/The-Noises--Update-for-08-May-09/ . Since I seem to have some time on my hands I will attempt to answer the question as well as I possibly can. The query was “Can we get buy/sell ideas from RSI data..?”

RSI like MACD is and oscillator -- Meaning that it oscillates about a mean to two extremes. An oscillator is called a leading technical indicator which fluctuates above and below a centre line and normally has an upper band and a lower band that would ideally indicate overbought and oversold zones. 

The indicator indicates accomplishes this through a formula that compares – basically the size of recent gains for a particular stock or financial instrument  to the size of the recent losses. The results thus plotted fluctuate between 0 and 100. There are bands placed on the upper end above 70 and on the lower band below 30 that are related to extreme overbought and oversold conditions.

There are three ways how the RSI is used to trade on the markets. At this point please do remember that no one indication can tell you exactly how and when to trade. All indicators are to be taken with other indications and the markets themselves.

 The first way the RSI is used to trade is seeing extreme over bought or over sold zones. I have inserted an example of ICICI bank behaviour in this march. It was in oversold territory this march and then the recovery started. The recovery has been pretty smart till now. If you now observe the ICICI bank is flirting with the overbought territory and it would be interesting to see how the next few days/weeks pan out.

 The second way the Indicator is used for trading is Centreline crossover. That means that when the markets cross the centreline the positions are built – either bearish or bullish depending upon the direction of the crossover. In the example you see that as the RSI crosses over from below the 50 marker to above it – the stocks takes cue and then goes higher. This crossover happened in the third week of March for L&T.

The Third manner in which the RSI is used for trading is Trading RSI Divergences. Hey I have been shouting Divergence on our charts for quite some time if you have noticed. The divergence means that the Markets are making new highs and the RSI is not making new highs or Markets are making new lows and the RSI is not making new lows. I will give and example of this that I have given before – see the Nifty. It made new highs in Jan last year and the RSI was not moving in consonance with the markets – let us say in other words The RSI was not sharing the enthusiasm of the markets. That led to a fall. And very sharp one that is.

I would end now by trying to rub in the fact that no single indication can give you an indication and you can trade it. You have to perhaps take multitude of factors and keep them in the mind before you can trade. Out of the three conditions we have two of them in front of us at this very moment and it would be nice to test our trading by RSI. The second aspect is that RSI may generate a sell or a buy signal – but it may take a long time for the markets to follow it. Where we go wrong perhaps is that we want instant gratification. We go short thinking that the markets are overbought – well if we are in a bull run then the markets can remain overbought for a considerable period of time – disgusting us out of the markets and the trust of the indicators. So best is – do not trade time bound instruments from short term perspective using RSI – you can perhaps buy stock and sell stock using this indication and not futures and options. All the same the indications are a truth and the markets do tend to reward if we follow a methodology using whatever tool we have. In army we often say – it is not the machine that lets you down… most of the times it is the man behind the machine that is incapable.

Hope that this effort of mine will make someone of you a millionaire.

Cheers !!