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6 Myths About Trading the Relative Strength Index (RSI)

6 Myths About Trading the Relative Strength Index (RSI)

By Cold Blooded Shiller - 05-Mar-2024

The Relative Strength Index (RSI) is easily one of the most popular and most misunderstood technical indicators in any market, but this is especially true in crypto. General poor understanding of this indicator leads to terrible trades and lost money – but that doesn’t need to happen. This article attempts to put traders who monitor RSI in the right frame of mind to interpret the data collected by this indicator and (as momentum traders) act on it. 

What is the Relative Strength Index?

Anyone reading this article probably has a basic understanding of RSI. But here’s a quick overview anyway. 

  • The most basic purpose of the RSI is to serve as a technical indicator that captures recent price action to visualize strength or weakness in the market. 
  • As a momentum indicator, RSI can be useful for capturing opportunities presented by overbought or oversold conditions. 
  • RSI can be a valuable tool in any trader's system for monitoring momentum, potential reversals, and overall strength, but learning how to correctly interpret RSI data is essential.

Misunderstanding this indicator can result in taking trades based on false or incorrect signals if the appropriate context for understanding RSI is ignored. Keep reading for some in-depth RSI myth busting. 

Myth 1: Overbought means sell. Oversold means buy.

Just because price drops or climbs and the RSI is in an overbought or oversold region does not mean this information is helpful in any way, shape or form to a trader. Markets can remain overbought or oversold for a very long time, and traders can lose their shirts incorrectly assuming “overbought means sell” or vice versa. 

Traders should absolutely never expect a market to top or bottom just because the RSI shows that an asset or index has reached an oversold or overbought region. This clownery leads directly to poverty. 

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Myth 2: Every RSI level is important.

As the indicator oscillates, it’s essential to realize that every tick does not matter and some levels are not as important as others. In fact, the most important level on the RSI is actually the 50 level. 50 RSI is the midpoint, and trading above or below it usually represents either a continuation or a break of a trend. Thus, market momentum can be expected to move in that direction. 

The 50 RSI level is a make-or-break level for trends. When it is lost – especially on higher time frames – it is SIGNIFICANT (yes, all caps). Losing this RSI level shows a clear change in the market momentum and traders should appreciate this change as such.

During strong trends, traders will often see RSI hit the 50 mark (personally, I call this a “reset”), and it offers one of the best entries a trader can hope for during strong high-timeframe trends. If the 50 RSI level holds, price will continue along the current trend, and traders will have a very clear and simple entry point. In short, the 50 RSI level acts as a sort of support or resistance level for momentum. Maybe RSI reaches the 51 level, but no 50 – that doesn’t mean it’s invalidated. Always use common sense around the 50 RSI level. 

Myth 3: All divergences are equal.

Divergences between price and RSI are an important (and often popular) method of interpreting RSI signals. Here are a few tips for reading divergences (“divs”). 

  • All divergences are strongest when they occur in the extreme areas of RSI. 
  • Divergences are strong when they are more than 14 candles in length. (RSI by default has a 14 period lookback range.) 
  • Avoid acting on outrageous divergences that don't match the data by mismatching lookback ranges or divergences outside of RSI extremes.

Myth 4: RSI is the only indicator that matters.

It’s possible that this is the most ridiculous myth of all. Any traders reading this need to know that the RSI is a supporting tool that can help improve timing and accuracy on entries and exits. But it must always be used in conjunction with basic technical analysis, like basic support or resistance levels on the price chart. The RSI can also be used with confluence from other indicators a trader might prefer, but it should never be used in isolation. 

The RSI is a highly context-dependent indicator, and prioritizing basic technical analysis of price action (e.g., horizontal levels of support or resistance) is always a good idea.

Myth 5: RSI divergences are easy money.

Always expect divergences to fail. When using the RSI, traders will often be positioning themselves counter-trend. So, it’s important to assume a potential divergence will fail. But when it doesn’t fail, there’s good money to be made. Let the market prove that it has strength, and enter when there is significant evidence of strength (in either direction).

Also, note that higher time frame divergences take a long time to form and then a log time to play out. Most traders will not survive this length of time or the accompanying volatility. During these time periods it is essential to be relentless about managing risk.

But these higher time frame divergences (especially on the weekly chart) have the ability to indicate strong macro trend changes. Divergences on the daily chart are very good for a very strong bounce without changing macro direction.

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Lastly, traders can use a sort of domino effect to position into divergences early. For example, if a trader notices a daily divergence forming, they can check the 4-hour chart. If they see a 4H divergence confirmed, they can enter the position from the 4H chart with an expectation that a small bounce confirms the daily chart’s divergence and they can ride the trade longer.

Myth 6: RSI is an easy indicator to use.

RSI is one of the indicators most often recommended to new traders. But the reality is that RSI is so poorly used and even more poorly understood, so it gets an awful reputation. Even though it may not be easy to simply put the RSI on a chart and print money, the steps to understanding the RSI and effectively using it are not hard – it’s not rocket science, as they say. 

In short, the real lesson to using the RSI is to understand whatever indicator a trader is watching inside and out instead of just expecting the RSI or anything else to provide miracle signals. The RSI is one of the most simple, effective and useful indicators for monitoring market momentum. It also helps check a trader’s bias, identify swing positioning opportunities, and when to join a trending market. 

Hopefully, any trader who reads this can more effectively use the RSI in their trading. 

This article is an adaptation of a thread written by the same author and posted to Twitter here.