Recently one of the members of our Mentor Program told us that they had been told that they should always sell a stock when the RSI became overbought and I thought what a stupid idea. For those not in the know, an RSI or Relative Strength Index is traditionally defined as being overbought when it reads over 70. So I decide to have a quick look at this as an idea knowing full well from past experience that it wouldn’t work.
The chart below of JIN shows periods where the RSI is above 70 and therefore should have been sold. For reference, I have added a simple breakout system and a simple ATR-based trailing stop based upon the initial entry.
As you can see JIN spend most of its recent run with an RSI above 70 therefore in the strictest interpretation of this rule the stock is a constant sell. But rules are binary if you must sell it when it is over 70 then you cannot buy it when it is over 70. As a consequence of this, you would have missed the initial breakout and most of the subsequent continuation signals.
If we look at the wider history of JIN we can see that once price breaks from congestion then the stock spends most of its time technically being overbought and therefore according to this rule it is off limits.
Once price begins to move it is natural for it to appear to be overbought – this is just a function of the way RSI is calculated. Once a stock has more winning periods than losing periods the RSI will begin to tick up. But as a trader, the one thing you want in price action is more wining than losing periods and these winning periods can continue long after an arbitrary boundary on a chart,