The Relative Strength Index (RSI) is one of the most popular technical indicators that can help you determine overbought and oversold price levels as well as generate buy and sell signals. The RSI Indicator has proven to be quite useful to gold traders and investors. It could potentially help to identify local tops and bottoms.
Overbought vs. Oversold
The basic principle on which the RSI operates is that it is based on historical prices of an asset. These past prices are used to calculate a number between 0 and 100. This number is the RSI reading. The way the RSI operates is mostly that the indicator falls when the price of the asset itself falls, and rises when the price of the asset rises. Significant or prolonged declines in the price will drive the RSI closer to 0. Significant or prolonged appreciation will propel the RSI closer to 100.
The importance of the RSI can be linked to the fact that extreme market conditions will usually lead to extreme readings on the RSI. For instance, in times of panic prices tend to drop like a stone. However, it is also a quite well known adage that “it’s best buy when there’s blood in the streets.” The times of extreme pessimism, selling and turmoil in the market can also be times when there’s not much more selling left as almost everybody willing to sell has already done so. Panic or selling can be contrarian signals. They are also periods when the RSI readings are likely to be extremely low. In this sense, the RSI can be viewed as a gauge of whether a lot of selling has happened in the market. We would call very low RSI levels “oversold” as there might not be more selling left. Traditionally, levels below 30 are considered oversold and taken as a potential indication of a local bottom.
The flip side is that in times of excessive optimism or buoyant buying, the prices tend to go up a lot. The RSI obliges and follows suit in the direction of 100. But it might just be the case that the buying power is drying up – when there’s been a lot buying going on, almost everybody willing to buy might have already done so and there might not be much buying left. And so, extreme buying might be a contrarian indication of a local top. The RSI close to 100, usually above the 70 threshold, can then be considered as a sign of a potential local top and we call levels over 70 “overbought” as there might not be much buying left.
The discussion of overbought and oversold levels, and the way the RSI works has been quite general so far. Let’s make it more concrete by focusing on gold. We focus on gold in the 2011-2018 time frame.
Further, we specifically look for situations when the RSI for gold went above 70, the classic oversold level and an indication of a potential top. If we take a look at the way the price of gold behaved when the RSI hit 70, it becomes obvious that all such instances coincided with at least local tops. The RSI seems to be eerily effective as far as the identification of local tops is concerned in the analyzed time horizon. This means that gold traders could potentially incorporate the RSI into their analysis to pinpoint moments when gold might turn around and form a top. If you are not inclined to do this on your own, we do so in our Gold & Silver Trading Alerts.
How can we make this even more concrete with a specific trading strategy based on the RSI? Let’s consider a following setup: we go short whenever gold’s RSI goes above 70. We close out the position when the RSI falls below 30. Also, we limit the focus of this strategy to the period when we had already informed our subscribers that we thought it was a good idea to get out of the market with the long-term investments. This means looking at the period starting in April 2013. We focus on the cases when the RSI went visibly above the level of 30.
We see that in all but one case, the strategy actually goes short during periods of declines. The one case when the results are mixed is 2016. But even then, depending on the precise entry and exit points, the position is not a sore looser. In other words, using the RSI in the described way in 2013-2018 would have resulted in only one missed shot and not by much. In other words, the strategy would have worked in 2013-2018. And this is during the period when there was no prevailing trend throughout the period, so the potential gains on this strategy would have not depended on one big lucky bet but a series of calculated ones.
On this chart, we see that the RSI displayed a curious pattern throughout the bull market. In specific cases, there was an initial move to or above the 70 line on the RSI, followed by a move lower in the index and then another move higher, which topped above the 80 level and was followed by a move lower in the RSI. This specific pattern in the RSI turned out to herald very significant long-term tops, the ones in 2004, 2006 and 2008. Was the next top also subject to this pattern?
Yes, it was. So, using the RSI to analyze the silver market, and in particular using this specific pattern in the RSI as a top indicator, could have been quite helpful to silver investors and traders, as silver went down massively in 2011 and actually ended the whole 2000/2001-2011 bull market almost exactly when the discussed signal was flashed.
What’s important about the two examples we have given so far is that investors can use the RSI in more than one way. There are the moves above and below the classic levels of 70 and 30. But there are also more elaborate patterns in the RSI like the initial move above 70 and a second move above 80, or even whole buy and sell strategies based on the RSI. There are many more ways to use the RSI and we feature the ones which, in our opinion, are likely to work in given market conditions in our Gold & Silver Trading Alerts.
The RSI is one of the most popular and widely used technical indicators that provides us with many ways to generate buy and sell signals. These include automatic line-crossover signals as well as more sophisticated visual ones. It can also be used to tell the general state of the market in question by identifying areas where the market is overbought and oversold. The many ways to use the RSI makes it a flexible tool that can be used in various ways in varying market conditions. We make the job of choosing the specific way to interpret the RSI easy for you by looking at the indicator and coming up with the way in which the indicator might be best used in our opinion in a given situation. In our Gold & Silver Trading Alerts, we do just that, and more, since there are many more indicators and other tools that can be used to trade gold and silver.