From book: RSI: Logic, Signals & Time Frame Correlation by Walter J. Baeyens
Now, for the sake of completeness we are ready to look at the initial RSI rules. I am sure that you are already familiar with some of them, as they keep appearing in many of the present-day technical analysis manuals and websites.
Here is what I learned back then. The main RSI signals, we were told, were:
-The RSI hits or exceeds values of 70 or 30, signaling overbought and oversold conditions respectively.
-Divergence between price and the RSI signals imminent trend reversals.
-The RS I crosses the 50-line up or down, meaning the market turns bullish or bearish.
- The swing failures, meaning the RSI reverses course.
Let's have a closer look at each one of these points.
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The fractal analysis of the markets is used in the indicator operation algorithm. According to the fractals theory, after the breakthrough of the fractal level confirmed by the closing price located below or above the fractal, the trend wave in the direction of the breakthrough starts to develop. Until the fractal has been passed in the opposite direction, the trend is considered to be acting even if the price is flat or moves backwards. If a bullish fractal has been previously broken through on
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Overbought and Oversold Levels:
As demonstrated earlier, the mathematical resistance of the RSI is a built-in feature that takes effect around the 66 and 33 levels. This means that more often than not, the Relative Strength Index value will have a hard time moving past these levels. But does
this j ustify the conclusion that these levels signal the market trend is exhausted?
We know that a tiny movement in the RSI value, when it is over 66 or under 3 3 , corresponds to a relatively large move in price. This means that at the R S I 70-level, the best may be yet to come in a strong uptrend. This is not in terms of further important j umps in the RSI value, but in terms of prices moving up strongly. Conversely, in a downtrend there is a huge down potential for prices while the RSI value is below 33!
Also, in my view, any claim relative to RSI signals should specify from which time frame the signal is taken. Imagine that we have been in a strong uptrend for the last five trading days. Would it make sense to determine that this rally is coming to an end just because the RSI hits the 70-level in a I 5-minute chart? In reality, the I 5-minute RSI will hit the 70-level several times a week in a rally of some magnitude.
When the I 5-minute RSI reaches the 70-level, the RSI value on the daily chart may be at 60, with plenty of UP potential. We may be tempted to assume the daily time frame was the main object of Wilder 's research, but it is clear that we will need to find a way to correlate the various RSI pictures. It is not hard to imagine the following scenario:
The RSI hits 30 in the daily time frame, allegedly signaling oversold conditions, while the weekly RSI may be at the 40-level, suggesting there is stil l a distance for the market to go on the downside.
From this illustration, it becomes clear that RSI levels signal different things when taken from different time frames. Hence my conviction that any conclusion drawn from a given RSI picture will be incomplete unless it is correlated to other time frames.
What should be made of Price/RSI divergence? Imagine that the daily RSI hits 75. According to Wilder, this would indicate that the rally is about to end, while prices
continue to hit new highs with the RSI meandering to the downside. (This is the definition of Price IRS I negative divergence). In this example, some will say the RSI worked off its overbought condition. However, since prices kept rising, there really never was an overbought condition.
There is no such thing as an overbought or oversold RSI and there are no such things as absolute overbought/oversold price conditions. In fact, there are plenty of examples of up-trending markets with major price jumps taking the RSI well above 70, even in the weekly time frame. In bear markets, you will often see prices accelerate their slide as the RSI value appears to be locked down below 30 for an extended period of time.
My advice: Do not let the 70 and 30 RSI levels fool you into initiating countertrend positions; it needs to be put in the correct perspective .
Figure 1 .2 I B M Weekly
This weekly chart shows a strong rally in IBM from 1 996 to 2000. I have drawn a horizontal line at the 70-level. If we had blindly applied the Wilder rules for RSI
interpretation, we would have sold IBM in Quarter 1 of 1 996, when the RSI reached the 70-level. But look what happened after that. After a mild drop into mid- 1 996, the market rallied and the RSI reached the 80-level by the end of 1 996. Prices continued to rise, while the RSI peaked well above 70 several times in 1 997 and 1 999. The fact that the RSI never dropped below 40 until Quarter 4 of 1 999 is typical of such a strong rally.
This chart is not exceptional. There are plenty of examples that show the RSI exceeding 70, after which the rally continues and strengthens. I believe it is closer to the truth to say that the rise of the RSI above 60 is typical of the start of a rally than it is to say that the RSI reaching 70 signals the end of the rally.
inevitable; thus we should not search for any magical properties here.
After the initial trend pushes the RSI to its limit, given the significant relative increase in momentum in the recent past, the RSI flattens out or even declines, simply because the rate of increase in momentum is decreasing, while the trend keeps going. More than anything, the existence of Price IRS I divergence confirms the present trend. Look at the evidence.
A negative divergence occurs when price reaches a new high, while the RSI only makes it to a lower high. By definition, when prices hit new highs, we are looking at an
uptrend. A positive divergence occurs when prices hit lower lows, while the RSI values already rise, hitting higher lows. By definition, when prices reach lower lows, we are looking at a downtrend. So, an interesting point about Price/RSI divergences is that negative divergence occurs only in an uptrend and positive divergence occurs only in a downtrend. Obviously, this statement is an oversimplification, but should be included because this is how Andrew Cardwell treats divergence in his Trend Determination Checklist. He sees divergence as one of several symptoms accompanying a trend. It says that the market is in an uptrend as long as there are higher highs in price. To that I would add: That is correct, whether or not there is a negative divergence. In other words, do not worry about negative divergence until you see lower highs in price.
Divergence occurs frequently and it does not have any special significance.
I like to think of Price/RSI divergences as follows : In a strong downtrend driven by longer-term traders that continues for several weeks, the RSI value in the hourly charts will be propelled down below the 30-level in a matter of days. But the price decline is far from over. What happens next? The RSI value is pushed even lower, let's say to the I S-level. But the price drop is still not over. The daily RSI value drops below the 3 8- level and appears to have further to go. Then what happens? The hourly RSI, at some point, hits its minimum value, meaning the maximum momentum of the decline is unable to push the RSI down any further. Remember the extraordinary down/up ratio that is required (in the last 1 4 hours) to push the RSI below the 20-level and the 1 0-level.
The RSI is being compressed at the bottom of the hourly chart, but the price drop continues (let's say that the daily RSI reaches 32). The hourly RSI has nowhere to go
but up, as down momentum in relative terms is not increasing sufficiently to depress it further. Consequently, the RSI starts to curl up in the hourly chart, while prices continue their drop.
We will treat RSI divergence in accordance with the general rules that will be defined later, meaning they need to be understood as a particular RSI behavior within RSI