The year 2024 has been largely an easy one for the stock investor. A forgiving one. Returns were mostly large, irrespective of where you entered and when you entered. At least for most months. Mistakes were forgotten, and even rewarded, just like mishits sailing over the boundary line in cricket. Until October. Technical Analysis was easier, not just because breakouts and bullish continuation patterns were aplenty, but with Nifty registering positive returns every month, except for January and May which registered -0.3% and -0.33% returns respectively, confidence was high for traders wanting to dig into dips. Until October.
Until October, one branch of the key technical indicators that assisted traders religiously was oscillators. There were at least five occasions where Relative Strength Index or RSI, one of the most popular oscillator bottomed out on falls below 45 giving buying opportunities until reaching 60 or above. However, in October, all this changed, with RSI plummeting to 30, without giving any opportunity for performance for the signal that had worked amazingly till then. Why would that be the case? Before trying to understand that, let us first look at two common ways of using signals from RSI.
• RSI is usually considered overbought when above 70 and oversold when below 30. However, like all technical indicators, the success lies in being flexible to interpret or adjust settings depending on the nature of the asset. We have found from experience that RSI can swing between 40-60 in an uptrend and stay in the 60-90 region for extended periods during very bullish markets.
• Spotting price – RSI divergence is another way of using RSI. If underlying stock/index makes a new high or low that is not reflected in RSI, it is called a divergence, which is usually considered as a signal towards price reversal.
Let us now get back to why RSI fails to function as an oscillator at times. The reason lies behind how the indicator is constructed. The central theme of RSI is the number of up days and its quantum in comparison to that of the down days. In other words, RSI seeks to measure strength relatively. And the results can vary vastly depending on the time period chosen. Hence, the usage of RSI indicator by itself to exit when the stock or index is at overbought levels and enter when the RSI is oversold may not work equally well in all situations. If you think that it is okay to not expect success in “all” situations, then it pays to note that it is in those few situations that markets gain momentum and taking a contrarian position may end up wiping off all the gains that one may have made while playing oscillating markets. In practice, we generally prefer to use RSI as a momentum indicator rather than a reversal indicator, while modifying the settings to fit different trends or asset class.
