Last Updated on 17 November, 2020 by Samuelsson
The Relative Strength Index is known for being a fairly good indicator of overbought or oversold securities. However, many people fail to understand how changing some of its parameters such as its timeframe can impact the trade signals. As such, they may fail to set the correct period that corresponds to their trading strategy.
The best timeframe for RSI lies between 2 to 6. While the default 14 periods are fine for many situations, intermediate and advanced traders can decrease or increase the RSI timeframe slightly depending on whether the position they are entering is long-term or short-term. Short-term traders should prefer shorter periods while long-term traders should gravitate towards longer periods. However, generally, the best edges are found with timeframes between 2 to 6.
All this can be a little confusing. So, let’s take a look at why and how a different timeframe for RSI can help generate better trade signals.
How Timeframe Changes RSI
The RSI uses data from previous trading sessions to come to a reasonably accurate conclusion of the stock being overbought or oversold. When you decrease the timeframe of the RSI, the index has fewer data to draw its conclusions from. As such, the chart becomes more sensitive as you continue to decrease the periods.
Conversely, increasing the timeframe for RSI increases the amount of data that is factored into the calculation of the index. Because of this, the data becomes less sensitive and there are fewer signals for you to base your trade upon.
You might be wondering why anyone would want a longer RSI timeframe. Won’t more signals be better for traders as they will provide them with more data to base their trade upon? Well, not quite. Although shorter periods tend to generate more signals, they are less reliable than signals generated by an RSI with a longer period.
When to Use a Shorter RSI Timeframe
A shorter period generates a lot more signals and thus is better for short-term traders. Short-term traders should be able to use the increase in the number of signals to better ascertain the immediate trend of the chart and go long or short based on their findings.
Take a look at the chart above. This is an RSI with a timeframe of 14, where the area between the lower and higher thresholds are marked with color. As you can see, there are a total of 3 oversold indicators along with 4 overbought indicators. You can also see that the oversold indicators are quite small in their size when compared to the overbought indicators indicating that people are generally quick to scoop up the stock as soon as they see a significant drop in its price.
Once you switch to an RSI with a timeframe of 10, you immediately notice an increase in the number of signals generated by the index. Short-term traders will now have more data upon which to base their strategy for trading at the expense of each indicator being a little less reliable than it would be if the timeframe was 14.
Adjusting For Volatility Levels
Another point to remember here is that certain securities will inherently be less volatile than the average ones. A perfect example of this is the S&P 500. If you were to compare the S&P 500 to the companies that are in the index itself, you will find the S&P 500’s RSI to be much smoother and have fewer signals than the individual stocks. As such, you will probably benefit by decreasing the timeframe when reading the RSI of the S&P 500 because you will have more data to work with.
On the extreme end of things, day traders often use RSI which has a timeframe of mere hours. This is, of course, highly risky and should only be attempted by professionals who have extensive knowledge in the craft of day-trading.
When to Use a Longer RSI Timeframe
Longer timeframes work in an opposite manner to the shorter timeframes. An RSI with 20 periods or more will have fewer signals for traders to use. However, these signals are much more reliable and indicate overbought/oversold commodities much more accurately.
This is the same chart that was used previously, but now the RSI timeframe is set to 20. You can see that there is only one point in which the stock was oversold if you consider the data for the last 20 days. However, the overbought signals were much stronger and they are visible in this chart.
If you are someone who likes to hold stocks for longer periods, then using a 20-day period could be best. That’s because the signals upon which you are going to base your trade will probably carry more weight with the added length.
Another time when a longer RSI timeframe will be beneficial is when you are trading highly volatile securities. For example, Cryptocurrencies are extremely volatile and it will be difficult to read their RSI if you have a shorter timeframe since there will be far too many signals for you to interpret. Increasing the timeframe will allow you to smooth the curve a little bit and enter sensible positions.
Do remember that RSI is usually not used for extremely long term trades. Such trades are made by traders who base their analysis on fundamentals as opposed to technical factors. As such, it is very rare to see anyone using an RSI timeframe of more than 20. For the most part, those who do consider themselves advanced traders usually use an RSI with the period far lower than 14 so as to ascertain short-term trends.
Changing Thresholds When Manipulating RSI Timeframes
As you know, the RSI outputs a percentage which is meant to indicate a stock/commodity being overbought if the percentage is above 70, and oversold if the percentage is below 30. However, it is very easy for the RSI to breach these levels if you decrease the timeframe enough. As such, sometimes it is necessary to alter the upper and lower thresholds of the RSI.
There is no one correct Upper and Lower threshold limit. Some day traders like to use a timeframe of 2 with 80/20 bands while others like to measure their timeframe in hours with bands often as high as 95/5. The best way to determine the right thresholds for you is to start with the standard 14 period (70,30) setting and slowly determine your optimal settings based on the volatility of the security as well as the length of your trades.
On the other side, it is best if you do not change your thresholds from 70/30 when increasing your RSI timeframe. This is because the only reason why you would increase the timeframe is to have a more reliable signal for your trade. If you decrease your bands to 65/35 or 60/40, you will essentially be eradicating the smoothing effect of a longer timeframe.
The Relative Strength Indicator is a fairly reliable tool which can be used by both novice and advanced traders. For beginner traders, it is best to start using the tool in 14 periods and 70/30 thresholds, or 2 periods and 90/10 thresholds. However, you can use some of the aforementioned techniques as you start to become an experienced trader to have signals specifically suited to the security that you are trading.
Lastly, remember that the RSI, as good as it is, is never an absolute indicator of the price movement. As such, it is best if it is used in conjunction with one or two other indicators in order to have maximum effectiveness.