General principles

The standard interpretation of the RSI is that it identifies overbought conditions whenever it is above 70 (or 80) and oversold conditions when it is below 30 (or 20). High RSI values often accompany market tops and low RSI readings coincide with market bottoms.

However, the problem is a trend is actually a persistent overbought or oversold state. For example, anuptrend, which would be characterized by persistent closes above the 28-period EMA, will be accompanied by RSI readings above 50, and the RSI will never drop below 20 and signal an oversold condition. The strength of the trend shifts the RSI readings upward, well above the textbook definition for oversold.

Similarly, when a market is in a downtrend, price will be below its 28-period EMA and the RSI will be below 50, and possibly below 20. The prevailing weak market trend lowers the RSI readings.

The range of RSI readings provides a clue about the condition of the market. In a very stable trading range period the RSI would be expected to oscillate fairly equally between its upper and lower boundaries. On the other hand, the indicator’s readings will be pushed higher or lower depending on the prevailing trend.

Because an uptrend is a persistently overbought state, the range of RSI readings will be shifted upward in such a way that you should consider 40 as oversold. During a downtrend, the range of RSI readings are pushed down so that 60 should be considered overbought.

If market action has caused the RSI to flash a reading of 30 (indicating a weak market), and later the market rallies and the RSI rises above 50, it means price has crossed above the 28- bar EMA. Some traders would consider a crossover above a moving average to be an indication of a change to an uptrend. However, moving average crossover techniques are subject to many small “whipsaws losses,” as price will often just edge through the moving average, then reverse. The concept described above takes into account this tendency.

As a general rule, then, if RSI readings shift upward, look to take buy signals. If the RSI has a downward bias, you should be bearish. This is counter to the way the indicator is typically used — that overbought or oversold conditions should be faded.

The fact is, trends tend to last longer than people expect, so it pays to have a mindset to exploit the trend, not trade against it.