US Stock Indicators Tutorial: Detailed Explanation of Relative Strength Index (RSI) Overbought and Oversold Signals

Image Source: pexels

When the Relative Strength Index (RSI) is above 70, the market may be in an “overbought” state; when it is below 30, it may be in an “oversold” state. The core role of these two key levels is to help you initially identify potential turning points in stock prices.

However, trading is not as simple as executing trades just because you see a signal. Even if you follow the latest US stock news, relying solely on RSI can lead to incorrect judgments. Accurately utilizing these signals and avoiding their pitfalls is the key to successful trading.

Key Points

• RSI above 70 indicates a stock may be overbought, and the price may fall; RSI below 30 indicates the stock may be oversold, and the price may rise.
• Do not use RSI signals alone. Combining them with candlestick patterns, MACD, and other indicators can improve trading success rates.
• When RSI fails (becomes desensitized), strong trends may temporarily invalidate RSI signals. You need to adjust your analysis approach.
• RSI divergence is a more reliable signal. It indicates inconsistency between price movement and RSI movement, suggesting a potential trend reversal.
• Combine the latest US stock news to validate RSI signals. Fundamental information can help you make more comprehensive trading decisions.

Core Principles of the RSI Indicator

Image Source: unsplash

To truly master RSI overbought and oversold signals, you first need to understand the principles behind it. RSI is not a mysterious black box; its logic is very intuitive.

What is the Relative Strength Index (RSI)

The Relative Strength Index (RSI) is a momentum oscillator indicator, invented by technical analysis master J. Welles Wilder Jr. in 1978. It quantifies the speed and magnitude of price changes into a value between 0 and 100, helping you assess the intrinsic strength of the market.

You can think of RSI as a “market sentiment dashboard.” When the pointer is high, it indicates strong buying power; when it is low, it means selling power dominates.

Although RSI and the Stochastic Oscillator are both used to judge overbought and oversold conditions, their calculation logic and focus differ.

In simple terms, RSI focuses more on the “strength of rises and falls,” while the Stochastic focuses on “where the current price is positioned.”

RSI Calculation Logic

The RSI calculation may sound complex, but its core idea is very simple: comparing the average gains on up days and average losses on down days over a certain period.

You don’t need to calculate it manually; trading software does it automatically. What you need to understand is:

1. Period Setting: The most commonly used RSI period is 14 days. This setting, proposed by its inventor Wilder, strikes a good balance between sensitivity and stability, providing a reliable view of recent momentum.
2. Strength Comparison: RSI uses a formula to compare “average gains” with “average losses.”
   • If recent average gains significantly exceed average losses, the RSI value rises, approaching 70 or higher.
   • Conversely, if average losses significantly exceed average gains, the RSI value falls, approaching 30 or lower.

Therefore, the RSI value directly reflects the recent balance of power between buyers and sellers. A high RSI value means buyers have dominated the market over the past 14 days, while a low RSI value indicates sellers have the upper hand.

Practical Application of RSI Overbought and Oversold Signals

Image Source: pexels

After understanding the principles of RSI, you will now learn how to turn this knowledge into actual trading decisions. This section is the core of the tutorial, teaching you how to identify and effectively use RSI overbought and oversold signals.

Important Reminder: RSI overbought and oversold signals are warnings, not trade execution buttons. Trading solely based on RSI signals is extremely dangerous. A test of a trading strategy using only RSI signals showed that this approach ultimately led to net losses and high drawdowns. Successful trading requires combining RSI with other analysis tools.

Identifying Overbought Signals (RSI > 70)

When the RSI line breaks above 70, it tells you the market may be “overbought.” This means the stock price has risen too quickly and too sharply in the short term, buying power may be nearing exhaustion, and the price risks a pullback or consolidation at any time.

Taking Apple Inc. (AAPL) as an example, historical charts show that in late 2019 and August 2020, its RSI exceeded 70. Following these overbought warnings, the stock price experienced pullbacks. This clearly shows that RSI above 70 can serve as an effective signal for short-term price corrections.

Think of an overbought signal as an announcement from an upward-moving train that it is “approaching the station.” It reminds you to stay alert and prepare for possible price reversals, rather than jumping off immediately.

Identifying Oversold Signals (RSI < 30)

In contrast to overbought, when the RSI line falls below 30, the market may be in an “oversold” state. This indicates the stock price has fallen too quickly in the short term, selling power may be exhausted, creating conditions for a potential price rebound.

You can view oversold signals as a potential buying opportunity window. When a high-quality stock is excessively sold off due to market panic rather than fundamental issues, RSI below 30 often helps you spot such “wrongly killed” opportunities.

An oversold signal is like telling you: “The market may be overly pessimistic; it’s worth paying attention.” It is a prompt for opportunities, not an instruction to go all-in immediately.

RSI Overbought and Oversold Trading Strategy

A reliable trading decision is never the result of a single signal. You need a complete strategy that includes signal identification, price confirmation, multi-indicator verification, and risk management. Here is a four-step trading process you can follow:

Step 1: Observe RSI Signals

This is the starting point of the strategy. Your task is to continuously monitor the RSI of target stocks and patiently wait for it to enter the overbought zone (>70) or oversold zone (<30).

Step 2: Wait for Price Confirmation

After a signal appears, the most critical step is to wait for the price itself to form a confirming pattern. Candlestick patterns are the most direct evidence of price reversal intent.

• When RSI > 70 (overbought), look for bearish reversal candlestick patterns, such as:
  • Shooting Star: A candle with a long upper shadow and small body, indicating weakening upward momentum.
  • Bearish Engulfing: A large bearish candle that completely engulfs the previous small bullish candle.
  • Evening Star: A three-candle top reversal pattern.
• When RSI < 30 (oversold), look for bullish reversal candlestick patterns, such as:
  • Hammer: Appears after a downtrend, signaling a potential bottom reversal.
  • Bullish Engulfing: A large bullish candle that completely engulfs the previous small bearish candle.
  • Morning Star: A classic three-candle bottom reversal pattern.

Step 3: Verify with Other Indicators

To improve trading success rates, use other technical indicators to cross-verify RSI signals. The MACD indicator is an excellent companion.

1. Long Signal (Buy): When RSI rises from below 30 in the oversold zone and MACD shows the fast line crossing above the slow line in a “golden cross”, this is a strong buy signal.
2. Short Signal (Sell): When RSI falls from above 70 in the overbought zone and MACD shows the fast line crossing below the slow line in a “death cross,” this is a strong sell signal.

Step 4: Set Stop-Loss

No trading strategy is complete without strict risk management. Stop-loss is the last line of defense to protect your capital, especially when the market moves against your expectations.

• Set Stop-Loss Position: A simple and effective method is to place the stop-loss outside the candlestick pattern that confirmed your entry. For example, if you buy based on a hammer pattern, set the stop-loss below the hammer’s low.
• Use Fixed Percentage: You can also use a fixed percentage stop-loss, such as setting it at 5% of the entry price. This means if the price falls 5%, your position will automatically close to limit losses.

Remember, even if your technical analysis is flawless, sudden latest US stock news can instantly change market direction. Therefore, combining RSI signals with stop-loss orders and broader trend analysis is key to making comprehensive decisions and effectively managing risk.

Advanced RSI Techniques and Limitations

You have mastered the basics of RSI overbought and oversold signals, but this is just the first step. To become a more mature trader, you must understand RSI’s limitations and learn advanced techniques to handle complex market environments. This section will dive into RSI “failure” phenomena, powerful “divergence” signals, and how to combine fundamental information for more comprehensive judgments.

Beware of RSI “Failure” (Desensitization) Phenomenon

You may encounter a confusing situation: a stock’s RSI enters the overbought zone (above 70), but the price not only doesn’t fall but continues to surge. Or it stays in the oversold zone (below 30) for a long time without rebounding. This is RSI “failure” (desensitization).

The failure phenomenon reminds you: In strong trends, RSI overbought and oversold signals may temporarily “invalidate.” It tells you the current trend is exceptionally strong, not that the indicator is broken.

This phenomenon is particularly common in strong trending markets.

• Tesla (TSLA) is a classic example. During its rapid rise in 2020, RSI frequently exceeded 70 and stayed there for extended periods. Selling just because of overbought signals would have missed massive subsequent gains.
• Similarly, Apple (AAPL) after major product releases or Bitcoin (BTC) in the extreme market of late 2017 experienced severe RSI failure.

When market momentum is extremely strong, prices can continue rising while traders are reluctant to take profits. At this point, you need to adjust your analysis framework:

1. Redefine RSI Ranges: In strong bull markets, RSI’s active range may “shift upward” to 40-80. Here, a pullback to 40-50 may signal the end of a correction and a potential buy point. Conversely, in bear markets, the range may “shift downward” to 20-60.
2. Adjust RSI Period Parameters: The standard 14-period RSI balances sensitivity and stability. In specific markets, you can adjust it to reduce misleading signals from failure.

More Reliable Signal: RSI Divergence

If overbought/oversold signals are “alarms,” then RSI divergence is a more reliable and forward-looking “warning” signal. Divergence occurs when price movement contradicts RSI movement. It suggests the internal momentum of the current trend is weakening, potentially leading to a reversal.

The power of divergence lies in helping you detect momentum exhaustion before the trend fully reverses, allowing you to prepare earlier.

Divergence mainly comes in two types:

• Bullish Divergence: Imagine the price falls again to a new low, but RSI’s low is higher than the previous one. This tells you that although the price is falling, the “strength” of the decline has weakened. Sellers are losing control, signaling a potential bottom.
• Bearish Divergence: When the price keeps making new highs in a bullish scene, but RSI’s highs are quietly declining. This indicates the “fuel” driving the rise is running out. Although the price is still rising, buying momentum can’t keep up, signaling a potential top.

Combining price patterns and volume to confirm divergence can significantly improve entry and exit accuracy.

Validate RSI with the Latest US Stock News

Technical indicators are ultimately mathematical calculations of historical price data and cannot predict the future. A company’s earnings report, new industry policy, or sudden latest US stock news can instantly change market dynamics, invalidating technical signals.

Therefore, combining RSI analysis with fundamental information is a must-have skill for professional traders.

Think of RSI as your “technical dashboard” and latest US stock news as your “road condition navigation.” Only by combining both can you reach your destination safely and efficiently.

How to combine them?

1. Validate Signals: When RSI issues an overbought signal, look for negative latest US stock news to support your judgment, such as downgraded earnings guidance or regulatory investigations. If none, discount the reliability of the overbought signal.
2. Explain Anomalies: When RSI fails or gives confusing signals, check related latest US stock news. You may find strong performance due to better-than-expected earnings or market enthusiasm for a new product.
3. Find Opportunities: When a quality stock’s RSI enters oversold due to market panic, use news to determine if it’s a fundamental issue or just emotional overreaction. The latter is often an excellent buying opportunity.

You can obtain information through the following reliable channels to validate your technical judgments:

• TradingView: Not only a top charting tool but also integrates rich news feeds.
• Seeking Alpha: Provides in-depth stock analysis and Wall Street ratings.
• Yahoo Finance: Free and comprehensive financial news source.
• Dow Jones (WSJ, MarketWatch): Offers professional business news and market insights.

Remember, successful trading decisions are the perfect combination of technical analysis, fundamental analysis, and risk management.

Now, you have mastered the core rules of RSI: above 70 is a warning of potential pullbacks, below 30 may signal rebound opportunities.

The most important principle of RSI is that it is an auxiliary judgment tool and should never be used alone as a buy/sell basis. You must combine it with price action, moving averages, or volume for comprehensive analysis.

Finally, turning theory into practical experience is crucial. You can first practice simulation on tools like TradingView, or apply what you’ve learned on platforms like Biyapay to hone your skills in real market environments.

FAQ

What is the best RSI period parameter?

There is no need to search for a “best” period. 14-period is an excellent starting point because it balances sensitivity and accuracy. You can fine-tune it based on your trading style (short-term or long-term) and market volatility to find the setting that suits you best.

Does the RSI indicator work on all time frames?

Yes, RSI works on all time frames. You can use it on minute charts for intraday trading or weekly charts for long-term trend analysis.

Keep in mind that signal strength and response speed vary across different time frames.

Should I use RSI or MACD?

These two indicators have different focuses. RSI measures the speed of price changes to judge overbought/oversold conditions. MACD focuses more on trend momentum and direction. Using both together gives you a more comprehensive market view.

What does the RSI 50 level represent?

50 is the bull-bear dividing line for RSI.

• RSI > 50: Indicates buyers are dominant.
• RSI < 50: Indicates sellers are stronger.

It helps you quickly determine which side is dominating the market.