RSI – Probably the most misunderstood indicator

BUY when it is “oversold” and sell when it is “overbought” – this is what most traders, investors and even some technical advisors would conclude when using relative strength index (RSI) in technical analysis. But is this the right approach when using the indicator? RSI is one of the most used technical indicators but probably the most misunderstood.

Although the three main strengths of the RSI indicator are (i) determining overbought/oversold levels, (ii) discovering the positive or negative divergence against the price chart and (iii) centerline crossover, application on the first strength is normally used in a wrong manner!

The first mistake is to strictly stick to one level each for overbought and oversold levels. Yes, the founder of RSI indicator J. Welles Wilder recommended using 70 and 30 as the overbought and oversold levels, respectively. But this does not mean that it must be strictly adhered to.

Are they the correct levels for analyzing a price chart with its RSI having moved beyond 90 on the upside or below 10 on the downside? On the flipside, how are we to analyze another price chart where its RSI never moved beyond the 70 level or below the 30 level?

Hence, there is a need for some flexibility in determining the overbought and oversold levels. It should depend very much on the range of the RSI indicator for a particular stock or index over a period of time. The levels for a stock may be 70/30 as recommended by Wilder but for another, it may be 80/20 or a different combination.

An analysis on Chart 1 (below shows that an investor using an 80/20 preferred level for the stock will not be able to buy or sell the stock using this principle over the last one-and-a-half years although the underlying share price was volatile.


Chart 1, courtesy of NextVIEW Advisor Professional

The second incorrect usage is more astonishing – buy when it is oversold and sell when it is overbought. This makes us wonder whether we should sell a stock after its RSI crosses above the overbought level and buy after the indicator moves below the oversold level.

As if the RSI indicator is able to determine with high possibility the potential peak and the potential trough even before they are formed! If such an indicator is available, I don’t mind paying my one-month pay to purchase it!

By its name, RSI is an indicator which determines the strength of the underlying share price. For that reason, the higher the RSI escalates, the stronger the underlying share price would be. And when this happens, doesn’t it mean that there is a higher possibility for the share prices to move even higher when it crosses above the overbought level? If so, why sell? The opposite is also true. Why buy when the share prices become weaker?

Let us analyze Chart 2 below . If one were to buy upon the RSI going below 30 for the second consecutive day, he would have bought the share on 9 Oct 08 (closing price RM2.70; RSI-14: 29.03) and would have incurred unrealized loss of 40% by 24 Nov 08 (RM1.61; RSI-14: 9.71).


Chart 2, courtesy of NextVIEW Advisor Professional

If he were to sell the share on 13 Apr 09 (RM2.25) just because RSI-14 has crossed the 70 level for two consecutive days (at 82.22), he would have incurred an opportunity loss of 38% in six trading days as the price surged to close at RM3.12 on 21 April with RSI-14 at 92.74.

The question now is –: was Wilder wrong when he introduced the overbought/oversold principle? Certainly not! He has indeed been misinterpreted.

What Wilder had written on this principle is that in general, it is considered bullish for the underlying stock when the RSI rises above 30 and conversely it is considered bearish for the underlying stock if the RSI falls below 70.

He did not say what should be done if RSI crosses above 70 but instead recommended what to do if the RSI crosses below 70. And he did not suggest what to do if RSI crosses below 30 but instead recommended what to do if the RSI crosses above 30. This is also in line with the third strength of the indicator, which is centerline crossing.

Shocking? We should go to the original source and understand the indicators that we use in the right manner.

****

Article Contributed By Ameer Ali Mohamed. Ameer is Director, Financial Research of NextVIEW. He has a total of 20 years experience as a corporate journalist, investment analyst and fund manager, including as research head of two stockbroking firms and CEO/CIO of a funds management company.


Republished with permission. This article was published in the Just Say It column in Shares Investment (Malaysia edition) June 2009. You can get the latest copy of Shares Investment (Malaysia edition) at leading bookstores in Malaysia.