You Are Using RSI Wrong

Overbought and Oversold is Myth

We have all fallen into the trap as young traders. We hear about a stock that is oversold so we think now is the time to buy. Confirmation bias kicks in when we look back on our charts to see all the times that this would be the low of the stock and now we’re excited.

Firstly, if you happen to be there right now then congratulations. You have taken your first step into systematic trading. The bad news is, in this case, you have been led astray.

We are going to be focusing on RSI in this post however everything I mention here can be applied to most, if not all, momentum indicators. The issue with overbought and oversold as a way to get into and out of trades is that these conditions can last for long periods of time without breaking.  Below we see the RSI getting oversold on SI at $30 a share and remained that way as the stock moved to 10 and then to 0. 

Here are some basic stats on buying when the RSI becomes overbought and selling when it becomes oversold on the S&P 500. This strategy is a great way to underperform simple buy and hold without having to deal with all the drawdowns. This data goes back 20 years, so it’s robust backtest.

Overbought is even worse since you are dealing with unlimited upside and shorting into a strong stock (TSLA example below). If you shorted when the RSI was overbought, then you were just saved from being wiped out on the subsequent move. 

Lets look at the actual math behind RSI and what its telling us.

This equation tells us that all the RSI is really doing is telling us the average up move vs the average down move in a stock. This means the RSI will move high if there are more green candles than red or if they are larger on average than the red ones and vice versa.

Now we can see why conceptually using RSI as a reversal indicator will not work since we are building stocks that are getting sold off and then selling stocks that are showing strength. 

So if the textbooks are wrong and overbought/oversold do not work in the long run to outperform the market, then does this mean that RSI and indicators are useless? I don’t think so. 

We now know that the RSI tells us how the average moves up in a stock compared to the average down moves. This means if we are looking for strong names, we should be looking for stocks where the RSI is unable to get oversold for a long time and vice versa for shorts. Using these bullish and bearish RSI ranges we can quantify stocks that have had strong up moves and relative week pullbacks over a long period of time. 

Take a look at this stock with one of these bullish RSI ranges. This has been a really strong name with one of these bullish RSI names for over a year. If you contrast that to the market this year the strength of names like these vs the market are a great place to look for potential trades. 

You can find a scan for names like this from trade-ideas here https://go.trade-ideas.com/SH2o .Focusing on names that show strength will make sure that money is flowing into the name you are honed in on. Then you can apply your other analysis skills for entries and exits. 

I hope this outlines the importance of understanding the math behind the indicator you are using. Diving deep into anything you’re going to buy with your money is key, and make sure that the indicators you use are no different. Don’t be afraid to flip conventional thinking on its head. Trade safe.