Are You Using the RSI Indicator Incorrectly?

Andrew Cardwell explains how he uses the RSI indicator and why many traders may be using it incorrectly.

I am here with Andrew Cardwell.  Everybody talks about overbought and oversold with the RSI but it is so much more than that.  What do you think?

I have been using it since 1978, Welles Wilder's original concept of RSI, overbought, oversold, bull and bear divergences in 70 and 30. 

Divergences, Rob, are nothing more than overextensions.  You see a bear divergence.  It is not a reversal signal.  It shows the market is overextended and needs to correct.  Same at the bottom.  You see a bullish divergence; the market corrects up, and then starts down again.

A lot of people look at them for reversal signals, put the position on, and wait for it to happen.

Yeah.  I know very few people in the world, Andrew, that will look at the RSI as anything except an indicator of when the market is overextended, but that overextension can mean a whole lot more.  It can mean that the freight train has left the station and it is on the way.

I am seeing the RSI go to 80, 85.

That is like 11 on the volume indicator for a rock band.

Yeah.  If you are using a nine period or a seven period, it will probably register a 95.

Sure.

But, as long as I have been working with it, I never changed anything in Welles's original work.  It was still 14 periods, I use the 70 and 30, but I identify what I call range rules.  People are, by nature, bullish.  The market rallies, people get excited, it goes beyond 70.  Then the new overextension becomes 80.

When it sells off and corrects, those that missed it just back in, the other side doesn't come down to 30.  It comes down to about 40.

And everybody says, well I missed it the first time, I'm not going to miss it this time, and it goes back up.  When you are in this uptrend, you will see the upper half of the chart, 80 and 40, and when you go into the downtrend, people get very depressed when markets are going down, they are buying bullish divergences and thinking it is going to rally, and it doesn't, and sells off again down near 20.  When it rallies, it only rallies to 60.  The same 40 points just shifted and we've had it in the euro. We've had it recently in the Dow.

There was a lot of loss.  The momentum run early September, late September, created a bearish divergence. 

The market corrected, but when it rallied into the first week of October, had trouble getting above 60, the range rules were shifting.

And I've heard you say that this could be an early warning sign.  Nobody is really expecting it.  This could be an early warning sign that this bearish correction that we have seen in late 2012, if we are talking about 2013 now, we could be seeing something even more extensive, and that takes people by surprise. 

I think so.  It will.

We get caught up in the story sometimes but you are saying focus on the chart.

Well, I'm saying allow the market to show you what it wants to do, not what you want it to do.  If the range rules are suggesting that the market is down and has shifted, I think 2013, between here and probably June, there is going to be a lot of volatility and a lot of things that people don't understand.

And when people are scared, they will sell.  When they are excited, they buy, which is why the range rules are so effective.  But, I think seeing the way the markets have reacted since September, you know we started the year off, made a high in May, sold off into July, a high in September, and then a real loss of momentum going into October.

But the market did not break really hard in October because it is usually one of the worst months of the year so maybe the market made a low in October, and I don't really study a lot of, use a lot of seasonals, but if the high probability is for lows to be made in October and we were making highs and it is inverted, we could be going down into March and April.