RSI indicator for trading: basics and beyond

Divergence of relative strength index (RSI)

When you use the relative strength index (RSI) indicator for trading stocks and you notice a divergence between the RSI and the stock's price movements, this might mean great potential for your trades to be successful when bearish divergence or bullish divergence occurs. If the stock you are watching makes higher highs but the RSI makes lower highs, it might indicate a weakening uptrend. On the other hand, if the stock is making lower lows but the RSI is making higher lows, it might suggest a weakening downtrend.

Using classic RSI indicator signals for stocks

Let’s take a look at a backtest of a trading system based on the RSI indicator in an application for AAPL (Apple) stock captured from the Trading View community. In this particular case, the strategy is to keep a position open until it generates a signal in the opposite direction.

When you apply the RSI in its simplest form (buy when the RSI escapes the overbought area and sell when it moves away from the oversold area) it produces a similar result across all timeframes — a pretty consistent loss.

That happens due to a very simple fact: most stocks tend to stay within bullish phases for a long time, contrary to currency pairs, which tend to stay in trading ranges.

All oscillators will flash an ‘overbought’ condition in a strong bullish trend, which assumes opening a short position. - Conversely, long positions will be closed relatively early as the market quickly gets into the ‘overbought’ condition, and a trader needs to close the position.

Using divergence for RSI in stocks

You achieve better results when you use bullish divergence or bearish divergence. When the RSI indicator value remains in overbought territory for a long time, you should probably avoid short signals, or apply additional confirmation to them, while favoring long signals.

The dominance of long signals helps you maintain positions in the direction of trends. In the example below, you'll see entry points generated not just in the oversold conditions or overbought areas. That might seem to break the traditional rules, but overbought/oversold prices rarely occur for most stocks. Consequently, the number of positions you trade might end up being very low. That is why sometimes you might accept signals even outside those areas.

Pros and cons of using the RSI indicator for stock trading

In this section, we dive into the strengths and weaknesses of using the relative strength index (RSI) for stock trading. On the plus side, this technical analysis tool can help identify good entry points and produce a high win rate while being relatively simple to use. However, it's not perfect: it can often produce false signals, it may not add additional insights beyond price and volume, and its effectiveness can vary across different timeframes.

Advantages of the RSI indicator in stock trading

1. Stocks often establish long-term bullish trends. The RSI indicator can help to find a good entry point to join such trends.
2. The RSI indicator is relatively straightforward to use. Basic RSI trading strategies don’t require you to have a high level of trading expertise.
3. RSI signals don't require a quick reaction from you, as a trader, and usually give you enough time to prepare and execute a trade.
4. RSI is focused on mean-reversion trading signals, which happen more frequently than trending signals. In other words, if applied correctly, RSI may help you achieve a high winning rate.
5. Many RSI strategies have already been backtested with results publicly available. These include their application to stocks. Therefore, you don’t need to ‘reinvent the wheel’ or go through a painful process of trial and error when using the RSI indicator.

Disadvantages of the RSI indicator in stock trading

1. RSI does not work well when it comes to extended trends, and the stock market is known for extended bullish trends. For example, RSI may produce a lot of false counter-trend signals, if applied to an actively growing stock.
2. RSI is just an indicator, meaning that it is a derivative of the price. If you are a beginner trader, it may help you organize the data, but it can’t add anything specifically new to guide your decision-making other than price combined with volume.
3. RSI works with mean-reversion signals, which means that it can help a trade to catch the top or bottom of the price action. Mean-reversion strategies are not perfect and may produce losses if the stock price quickly breaks or continues moving in one direction, especially with gaps.
4. RSI is not very sensitive to price action. It may give you signals too early.
5. RSI strategies may perform differently across different timeframes, so you must apply in-depth research before using them.

Looking to trade stocks using the RSI indicator?

Remember, no indicator, including the relative strength index (RSI), should be your sole resource for making trading decisions.

You also need to take into account factors like market conditions and how close an asset price is to essential support or resistance levels.

For stocks, it’s important not to maintain a position over the earning report publication’s closed period. Stock prices can fluctuate significantly in the event of an earnings surprise. Learn more about how to trade CFDs for stocks here.

Treat the indicator as a guide, not as a ‘holy grail’ predictor of returns. Past performance of any indicator does not guarantee future success.

Ready to start trading stocks and test out the RSI? Open an account with Exness today.