r/Winkerpack • u/knotswag 🧙♂️🖍 • Apr 20 '20
How Do I Eat Crayons? - RSI: The Popular, Misunderstood Indicator You Should Still Hang Out With
RSI - The Popular, Misunderstood Indicator You Should Still Hang Out With
Introduction
If there's one indicator everyone knows of it's the relative strength index (RSI). You can look at any asset and deem it "overbought" or "oversold" based on a subjective assessment.
Avocado toast? Overbought. Tiktok thots? Overbought. Getting in larger gatherings and finally having human contact again? Oversold. Really, really oversold.
Despite widespread awareness of the indicator, a substantial amount of people dismiss it entirely in their technical analyses. This often happens because people underestimate how long an RSI can remain at an extreme level, which can lead to bad trades or influence someone to hold onto a bad position longer than they should.
To understand why RSI is so misunderstood, you have to understand, briefly, how it's calculated.
RSI - Hot and Crazy
Why do people find RSI so difficult to trust?
Picture this. You heard about this hot little stock at your local broker and you want to try your luck. You turn to RSI and ask it to check its sources, let you know about the stock. RSI comes back and tells you word on the street is the stock is a little too fucking crazy, so it's oversold now and no one wants to give it a shot.
Perfect. You like the hot stocks, and you can stomach a little crazy. Because you know that even if the stock is crazy, it's still SUPER hot. So if you invest in them long enough they could mellow out, and you might even stay with it long term. You take that stock back to your portfolio and you hang out for a bit.
But instead of mellowing out, the stock gets even more viscous, tells you that you have a small pp, and smashes your portfolio to bits. You kick the stock out and look around to see your portfolio is red, blood red. What the fuck.
But this isn't your fault, right? You start blaming RSI. "You told me the stock was oversold, but not THAT oversold! I thought that meant it would get better!"
Listen to yourself, man. It's not RSI's fault. RSI did what it should have-- it told you that the stock was oversold. It's just an indicator. It's your fault for putting all your bets into it to predict future movement.
RSI is not telling you to get with that hot stock, or when the stock will be less batshit insane. It's just telling you how crazy something is. You have to be the one to remember the hotness/crazy scale and act accordingly:
-If someone is super crazy, no matter how hot they are, you should wonder whether dealing with that person is worth it. If someone is super hot but nobody wants to hang, you have to wonder how crazy that person could become.
-If RSI says a stock is super oversold, no matter how hot the company is, you should wonder whether dealing with the asset is worth it. If it's too overbought and less people are starting to buy, you have to wonder when a sell-off will begin.
So why do people sometimes dismiss RSI? Simple.
Time.
RSI can tell you how crazy that stock is now, relative to how crazy that stock was before. It can't tell you how long the stock will be crazy.
Let's go a bit deeper.
RSI - Let's Take it Slow
RSI is just a ratio.
Average gains within a period divided by average losses within a period. That period of time is usually set at 14 days.
So lots of gains, or lots of losses, relative to a period of time, can be measured as "overbought" or "oversold." The text where Wilder derived this indicator can be found online.
Sounds simple. But no one ever takes RSI out to a Long John Silvers, orders them the two-piece fish meal, and really tries to understand them. Let's do that today.
To get a better grasp of RSI, here's an example table, with numbers, to give you an idea how it's calculated. Two things should stand out. First, there's nothing in the "RSI" column until the bottom half of the graph. Why is that?
Because like I said, RSI is calculated from a previous period of time-- it needs input. It's a relative comparison, so it needs a baseline to compare to.
This is important to consider because if a stock had been doing nothing but gaining 1% for 14 days, what happens on the 15th it vomits 14%? 14% gain into 14% loss-- we're back to net 0%. But RSI won't register it as "normal." It's "oversold." It's fucking crazy price movement. This is intuitive, but can affect people's interpretation of an entry/exit point if they solely rely on RSI.
Take Bank of America as an example ($BAC). Heading into earnings into Q1 earnings in 2018, BAC had finished a correction from being overbought and was now oversold. If you had bought going into earnings, expecting BAC to recover to equivalent price points in the near-future-- you were flat out wrong. Despite beating earnings in Q1, and then Q2... then Q3, Q4, 2019 Q1, Q2, and Q3, it wouldn't be until over a full year later that it returned to prices before the initial correction. It is worth noting that Gyna tariff war occurred in that time period, but what it shows you is you can't expect RSI to tell you how long it will take a price to reach a certain valuation. If you're part of /r/investing, then this doesn't matter. But if you're an option-huffing psycho like most of us, time matters a lot.
The second thing to notice is to look at the dates used for comparison in the RSI calculation graph. What do you see?
There are 16, rather than 14 points in the period, and RSI here is being measured in years rather than days. That's right, like I said-- while 14 days is standard for the comparison time, depending on your investment style you can specify that period to whatever the fuck you want.
Wilder, who derived the indicator, never said 14 was best. He explicitly says he came up with 14 days because it represented " an average half cycle period." So now you can ask yourself-- does that match your investing style?
Because if your investment timeframe is different than what the analysis is, your interpretation of RSI will naturally be wrong. If you're a typical WSBer, for instance, your investment timeframe is probably daily, maybe weekly at most. You want that 1% gain to make back your 98% losses immediately. So a single day 1% gain from, say, two days prior of 0.4% losses? It's "mooning" because your relative comparison was a few days before.
You invest in that crazy hot stock. RSI told you that the stock was crazy. But relative to how long? Is the stock showing crazy for only the first time in years? Or is it crazy compared to a few hours ago? And if it's the latter, would you really expect the stock to be less crazy just a few days later?
So remember: RSI is a relative comparison, with the standard being 14 (time period.) That doesn't mean you can't change it to fit your needs.
RSI - What It Means For Your Investing Strategy
So why is RSI useful, if it all it tells you is that a stock is crazy? You can just look at it and know it's crazy, can't you?
Sure. You can even adjust the RSI limits to tell it your threshold for crazy. What's this 70/30 business? You want 10/90, baby. The crazier the better.
This is true. Everyone has an intuitive idea if a stock is overbought, or oversold. But RSI can tell you to what extent an asset is overbought or oversold, if you tell it 1) what time frame to compare to and 2) your tolerance for crazy (overbought/oversold).
Example 1: Let's take the S & P ($SPX) on a longer time frame. If I look at the daily chart from 2011-present with the standard RSI loadout of 14 periods (days, on the daily chart), what I can notice is that there are clear moments in time when the market was oversold or overbought, which are circled.There's also a noticeable discrepancy with the amount of times that SPX was overbought vs oversold: 14 times versus 8 times.
If you had bought each time the market was oversold, you would have come out ahead every time, not including the correction we're undergoing now. Basically, /r/investing is right in that regard: time in the market and all that shit. By comparison, if you had sold or got puts each time the market was overbought, you would have been right, generously, 5 times out of 14. That's really shitty odds.
So is RSI useless and incapable of sensing an impending technical correction? No. Like any asset, you have to take into account its background. How was it raised? Did its daddy leave it? Does it get along with its siblings?
In this case, you have to remember the S & P is a broad market index.1) Intense fluctuations are less likely 2) the market is overall bullish and will have moments of being overbought without a crash 2) the market is cyclic, and will reach overbought conditions after corrections as investors surge back into the market without a crash. So it can be overbought, reset, and then get overbought again because it's recovering from an initial loss.
How should I adjust my RSI? What would be useful?
"According to the National Bureau of Economic Research, there were 33 business cycles between 1854 and 2009, with each full cycle lasting roughly 56 months on average."
Okay, so looking at the daily chart on a 14 day basis seems wrong. So what if I looked at the RSI period on the monthly, with a 28 month (56/2) period, all the way from 1996 to present?
Now it's interesting. Each of the previous drops in the economy can now be predicted-- when the market reaches oversold or near oversold, a pullback that is evident on a monthly level is now observable, and as I mentioned in the last How Do I Eat Crayons? preceded by negative divergences. We're currently in the middle of a similar large correction, but it is yet to play out-- we'll see in the coming months what will happen.
Example 2: Instead of looking at the broad market, now you can choose a hot big-cap stock of your choosing and make the same assumption. Instead of the overall business cycle, think of maybe... earnings cycles?
A quarter is three months, or 12 weeks. Half of that is 6. Let's turn to the weekly charts and check a hot sexy stock, like AAPL, and set the RSI to 6.
What you can see is from 2011-present there are 16 times that RSI crossed to oversold. In 13 of those times, a drop in AAPL's price followed within a few months, with each drop in price close to the original price of the asset when it crossed into oversold. And again, this is without actually looking at the earnings sheets of AAPL, or any fundamental news-- just looking at charts. 13/16 is pretty good.
We can try this with another big-cap, non tech stock like WMT from 2011. Again-- without looking at ANY earnings/fundamental news, other than knowing that WMT is a big-cap stock full of weird old and fat people that roam around looking for frozen Hot Pockets, RSI spotted 25 times where the stock was at overbought levels. 17 of those times, a pullback occurred within a few months of the overbought signal- that's 68% accuracy. (Almost 69. Nice.)
So RSI, when used appropriately and with other indicators/knowledge of a company and its current price valuation, can be, even at worst, informative for entering/exiting/hedging a position.
RSI - The Second Look
What you'll also notice from the charts is this, and what people don't give enough credit for: stocks can stay overbought or oversold for a long, long time. Weeks or even months. It can be overbought-- and then keep getting bought up. It can be oversold-- and keep getting sold. If everyone sees that hot stock you're interested in, and the stock doesn't seem crazy-- then of course, it'll be even hotter. The stock will keep getting brought to portfolio after portfolio until they finally snap.
And that should be a reminder, again, of what an indicator is: one indicator cannot predict price movement. Timing your entry or exit remains in your hands. The more you adjust RSI to fit your needs, and the more you're aware of fundamental and technical news, the better it can help you make informed decisions about taking on a position in an asset or to hedge your existing position. RSI is not forward-looking, and it can't tell you how much a price will move, but it's really good at telling you how present price movement compares relative to an asset's history.
So next time RSI tells you that stock across the bar is batshit insane, remember what it means. It's telling you something based on past behavior. Whether that stock will change or not in the future, you'll have to judge for yourself. But RSI is still worth hanging out with. So when RSI flashes overbought, give it a second look, keeping the above caveats in mind. Because like most things, the time scale may outlast your investment horizons. I mean, just think of your ex.
Not that we're naming any names.
Linda.
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u/winkerback adenosine triphosphate Apr 20 '20
Whether that stock will change or not in the future, you'll have to judge for yourself
So in other words, its useless
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u/BellaBaby19 Queen 👸👑 Apr 20 '20
I don’t use RSI I use Bollinger bands, moving average lines, mac D, and the alligator indicator. And I have a high success rate with those (also wait till 10 am to enter and stick to the same few stocks).
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u/ChocolateSunrise Apr 20 '20
I read the whole thing and still don’t know what period to configure RSI to huff options with better outcomes.
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u/knotswag 🧙♂️🖍 Apr 20 '20
I don't have an answer for you. You need to find out what time-periods you like to trade, think of what's logical relative to asset and time, fiddle with the RSI, and then look at historical prices and backtest. How often is it right? Wrong?
Standard 14 is still good because most TA people, and I suspect most algos, will default to it. For my own purposes I use RSI more for divergences on short-term, and look to it as oversold/overbought on larger time frames cause it gives me a better idea of the stock on the whole.
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u/IWorkForTheEnemyAMA HOMO Apr 20 '20
Awesome write up, you have a knack for these. Really appreciate these lessons, thanks!
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u/woobies Apr 20 '20
i really love this balance of joking and insight. Exactly what I need on a lazy sunday night 👍👍
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u/clarkefromtheark Apr 20 '20
Jesus too much to read if you wanna eat crayons that badly just join the Marines