RSI: How do we know that the market is overbought or oversold?
In the next part of our series exploring technical indicators, we introduce one of the most well-known momentum indicators, the RSI. The RSI often appears in our technical analyses alongside the MACD indicator, so these indicators may already be familiar to regular readers. The RSI is generally used to identify future trends and trend reversals, based on which we can determine buying or selling signals.
The RSI (Relative Strength Index) is a momentum indicator, meaning it is calculated not based on moving averages, but on average past price movements. The value taken by the RSI ranges from 0 to 100, where a value below 30 signals overselling, while a value above 70 signals overbuying in the market.
Like the MACD, the RSI is usually displayed below the price chart, and we can even place the two indicators one under the other. In many cases, it can be beneficial to observe the signals of both indicators simultaneously, making a trend reversal more clearly identifiable. Of course, it is true here as well that it's not advisable to rely solely on these indicators when making a trading decision, it's also worth understanding the fundamentals.
Signals and their interpretation
Generally, two levels are distinguished in interpreting the RSI signals, the 30 and 70 levels. If the RSI shows a value below 30, we can talk about an oversold situation, meaning too many sellers have appeared in the market lately compared to the average market condition. On the other hand, if the RSI enters the zone above 70, we can talk about an overbought market, at these levels it's worth handling investment decisions related to the current financial instrument carefully.
It's worth mentioning that the 30-70 boundaries are not objective, in many cases these can shift towards 40-70, for example in a rising trend, or even downwards to 30-60 if the examined price is mainly declining. However, generally, the 30-70 boundary is used, so it's mostly worth keeping these parameters in mind.
Similarly, to the MACD, we distinguish buying and selling signals based on the picture of the RSI. We can talk about a buying signal when the RSI crosses the 30 level from below, indicating the start of a rising trend from oversold levels. Logically, we can talk about a selling signal when the indicator returns from the overbought zone, meaning it crosses the 70 level from above. These signals are often observed alongside the MACD indicator, the joint position of the two indicators can even strengthen the signals.
Advantages and disadvantages
The RSI is a leading indicator, meaning it usually sends its signals before or at the same time as price movements. The advantage of this is that investors can take positions with higher yield potential than if they waited for the trend reversal.
However, its disadvantage is that it's less accurate compared to retrospective indicators and is more prone to give false signals. This is typically the case when the price of the examined financial instrument is in a major rally, or perhaps in a decline. In such cases, a minor pullback or correction can often trigger a buying or selling signal, but the direction of the price doesn't reverse. It's clearly visible on the GBPUSD price chart that it's not necessarily worth taking every selling or buying signal into account during a strong trend:
When is it worth using?
As mentioned before, the indicator tends to send false signals during longer rising or falling trends. Therefore, strategies based on RSI work most effectively when the price of the examined financial instrument moves sideways in a wave-like motion, or possibly moves in a minimally rising or falling trend. The S&P 500 index performed a wave-like movement during 2022, so if we had bought or sold the index based on the RSI, we could have realized a return of 14.18 percent. In contrast, a year earlier in 2021, the same strategy would have resulted in a 25 percent loss.
As you can see, the RSI does not always give accurate signals, but besides this, it can be suitable for timing buying and selling decisions, and we can also more easily identify overbought and oversold markets, thus we have the opportunity to avoid or take advantage of these situations.