Every trader should know about RSI or the relative strength index. The RSI offers traders essential information about a stock’s momentum in the market. However, is this information always accurate?
RSI doesn’t work every single time, although it’s mostly accurate. There are some situations that can cause it to fail, including when sudden, significant price changes occur. The system measures over buying and selling, so sudden changes can cause false readings.
There are three situations where RSI is more likely to fail. As a trader, you’ll need to know what signs to watch out for so you don’t make a decision based on a false RSI signal. I’ll cover all these situations further in this article, so read on.
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3 Situations Where RSI Indicator Fails
The RSI readings you see are there to compare bull and bear price changes. The indicator displays the readings in chart form, making them easier for traders to understand. However, while this is excellent information to have, that doesn’t mean that it’ll always be accurate.
The most accurate RSI numbers appear when there’s an ongoing trend. Long-term trends allow the system to assess the data better and make more reliable deductions. When RSI needs to make a predictive value, it has an easier time in a predictable market.
RSI indicators are helpful to traders as long as they know when it could give them the wrong reading. If you want to use RSI in your trading strategy, you’ll need to watch out for situations in which the indicator becomes unreliable. The three most prominent of these situations include the following:
RSI Fails When There Is User Error Involved
Not everyone knows how to read the RSI, and this is especially true for beginners. It can be easier for rookies to misinterpret the RSI, causing them to make lousy trade choices. If you want to understand what’s going on, you should spend time studying RSI.
RSI is a measurement of how fast trades happen and how the price moves. The index moves on a scale of 0 to 100. If the readings drop below 30, it’s likely the stock will oversell. The readings that reach 70 or higher indicate overbuying of the stock.
According to Fidelity, RSI readings at 30 or lower indicate excellent buying conditions due to overselling. On the other hand, RSI readings above 70 are optimal conditions for selling due to traders overbuying the stock. Also, the readings indicate price movements but don’t show any future price direction.
To summarize, the RSI is meaningless if you don’t understand it. Make sure to learn what it tells you about when to buy and sell. You can also combine it with other indicators for more reliable results.
RSI Is Not Perfect And Gives False Negatives and Positives
It’s important to realize that the RSI isn’t perfect. The longer the stock stays in an overbought or oversold state, the less effective the RSI is. You can get false indications when the stock stays at that point for months, which means you need to check how long the stock has been above 70 or below 30 before taking action.
If you think you’re getting false negatives or false positives from the indicator, you’ll want to use it alongside other types of indicators. That way, you can cut down on some unreliable factors.
You can tell that you’re getting a false signal if the long-term RSI indicates buying or selling conditions, but a short-term RSI says otherwise. Time can also impact the RSI reading, so don’t forget to take it into consideration as well.
Avoiding False Signals
Luckily, there are plenty more ways for you to avoid false signals from the RSI. One method is to use a smooth RSI, which shows you the average values in the indicator. Many professionals think it’s a good way to filter out some of those false signals.
This indicator works better since it takes away some of the false spikes you see on a traditional RSI. Plus, using the average price “smooths” out the chart, making it easier for traders to understand possible trends.
There are still downsides that come with a smooth indicator. The smooth RSI doesn’t react and changes as quickly as the other indicators.
RSI Fails When There Are Sudden, Large Price Changes
RSI measures the number of recent price movements in a stock. When there’s a sudden, large change in price, the RSI can produce false indicators.
These false readings can only occur if the price changes are significant. Since the RSI tracks a stock’s price, the readings can change when the prices move suddenly. These fast occurrences don’t give the RSI enough time to adjust, giving intense readings that could be wrong.
Make sure you check on the recent stock prices before buying an asset. You can compare the cost to the readings offered by the RSI. If you notice the stock’s price changed dramatically in a short amount of time, you’ll know not to trust the RSI readings.
In short, sudden fluctuations in price can greatly impact the RSI. It’s worth watching out for, so you can react accordingly.
Causes of Sudden Stock Price Changes
The most driving factor in stock price is supply and demand. The more people want the stock, the more expensive it gets. On the other hand, a sudden drop indicates sudden interest in selling.
There are often reasons why traders gain or lose interest in a stock suddenly. This market information is usually pretty easy to find with a quick Google search. You may notice that a spike in interest (on either side) in stock usually coincides with the business releasing their financial report recently. If the business reports they’re doing exceptionally well or very poorly, the stock price will react to that news.
Either way, sudden stock price changes can impact the RSI. You must realize this so that you can respond with a solid strategy.
Getting the Most From RSI
If you want to use the RSI to its fullest potential, you need to watch for divergence signals. These signals are more reliable than signs of overbuying and overselling. Many professional traders also use divergence in the RSI to turn higher profits.
RSI divergence occurs when the stock index has lower highs when the price’s uptrend reaches higher highs. When the price goes down, divergence occurs when it hits lower lows, with the RSI reaching higher lows.
It sounds confusing at first, but this YouTube video explains it well:
Adjusting the RSI Period
RSI often reads 14 periods’ worth of information in the indicator. However, many experts don’t believe that this default setting is the best for accuracy. Instead, you’ll want to adjust the periods to be between two and six.
Making this adjustment makes the RSI better for day traders. You get more accurate information in a smaller time frame, which is essential for performing those types of fast trades.
The best method is to configure the RSI period to match your trading strategy. That way, you can get more reliable results from the indicators. If you’re into short-term trading, then a short RSI period will suit you best, and vice versa for long-term strategies.
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Conclusion
In short, while very useful to traders, RSI signals don’t always work. You’ll need to know what to look out for, so you can buy or sell accordingly. There are three reasons the index can fail: if there’s user error, if there are false negatives or positives, or if there are sudden, large price changes.
You should always research every stock you want to trade before acting, and checking the RSI lets you know if it’s overbought or oversold, allowing you to react appropriately. If you notice the RSI is inaccurate, you can make better decisions and avoid financial mistakes.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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