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Lesson 06 · Mean reversion

RSI Trading Strategy: Buying Oversold Dips

  • 13 short cards
  • About 6 min to read
  • 5 quiz levels · 30 questions
  • Beginner

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Overview

This RSI trading strategy uses the Relative Strength Index to spot sharp, short-term drops in a market that is rising overall. It buys the drop and sells the bounce. The idea is called mean reversion: prices that stretch too far often snap part of the way back.

Timeframe
Daily charts (also 4-hour)
Markets
Share indices, ETFs, large company shares
Difficulty
Beginner

Builds on: Moving Average Crossover Strategy, ATR Stop Loss and Position Sizing

See it on a chart

95100105110115120BuyBuyBuy7030RSI
  • Price (candles)
  • 50-period SMA
  • Long signal
  • RSI (14)

Sharp dips push the RSI (lower panel) below 30. The buy signal comes when RSI climbs back above 30. Prices are made up for illustration.

What does the RSI measure?

The Relative Strength Index (RSI) was created by J. Welles Wilder in 19781. It compares the size of recent rises with the size of recent falls, usually over the last 14 candles, and turns the result into a number between 0 and 1002.

Readings above 70 are usually called overbought, and readings below 30 oversold2. These words can mislead. They only mean the recent move has been unusually strong. They don’t mean a price is cheap or expensive.

The RSI scale

OversoldNormalOverbought3070
0100

“Oversold” only means the recent fall has been unusually strong. It doesn’t mean the price is cheap.

The sum behind it: first find RS, the average gain ÷ the average loss. Then RSI = 100 − 100 ÷ (1 + RS). If gains and losses are the same size, RS is 1 and the RSI is 50. Your chart works this out for you.

Worked example: working out an RSI

Average gain over 14 candles
1.5
Average loss over 14 candles
1.0
RS = 1.5 ÷ 1.0
1.5
1 + RS
2.5
100 ÷ 2.5
40
RSI = 100 − 40
60

Gains a bit bigger than losses gives an RSI a bit above 50.

The mean reversion idea

After a sharp short-term drop, prices often bounce part of the way back. This tendency is called mean reversion.

A well-known version comes from Larry Connors and Cesar Alvarez. It uses a very short 2-period RSI, buys when it falls below 10 while price is above its 200-day moving average, and sells when price closes above its 5-day moving average3.

The 200-day filter matters. In a downtrend, an oversold market can stay oversold and keep falling.

The Connors and Alvarez version

  1. Check the trendPrice above its 200-day average
  2. Wait for a sharp drop2-period RSI falls below 10
  3. BuyAt the close or next open
  4. SellWhen price closes above its 5-day average

Choosing an RSI setting

The standard 14-period RSI reaches 30 or 70 less often than shorter settings do. Short-term traders often use a 2- to 5-period RSI with stricter levels, such as below 10 to buy. Shorter settings give more signals, and more false ones.

A standard RSI and a short one

RSI(14)RSI(2)
Typical buy levelBelow 30Below 10
How often it gets thereNot very oftenOften
SignalsFewerMore, and more false ones

When RSI signals fail

In strong trends, RSI can stay above 70 or below 30 for a long time2. Selling short just because a strongly rising market is “overbought” is a common way to lose money.

Mean reversion also has lopsided risk: many small wins, then sometimes a large loss when a dip turns into a crash. Always use a stop loss or a time stop, which gets you out after a set number of candles if the bounce hasn’t come.

Lopsided risk: many small wins, one big loss

  • Trade 1+0.8R
  • Trade 2+0.9R
  • Trade 3+0.7R
  • Trade 4+0.8R
  • Trade 5+0.8R
  • Trade 6+0.8R
  • Trade 7: a dip that became a crash−4.0R

Six small wins add up to +4.8R. One bad trade takes −4R. Without a stop, that one loss could have been far bigger. Made-up numbers for illustration.

Divergence

Sometimes price makes a new low but RSI doesn’t. This is called bullish divergence2. It hints that selling is losing strength. Treat it as a warning, not a signal on its own.

Bullish divergence

First lowSecond lowWhat it shows
Price£100£97A lower low
RSI2231A higher low

Price fell further, but with less force. It’s a warning that selling may be fading, not a buy signal on its own.

RSI strategy rules

Entry

  • Trend filter: price must be above its 200-day simple moving average, so you only buy.
  • Setup: RSI(14) closes below 30, or RSI(2) below 10.
  • Buy when RSI turns back up through that level, at the close or the next open.

Exit

  • Sell when RSI climbs back above 50–70, or
  • when price closes above its 5-day moving average, or
  • after 5–10 candles if the bounce hasn’t come (a time stop).

Risk

  • Hard stop below the recent low, or a set number of ATRs away.
  • Keep sizes modest: losses can be bigger than wins.
  • Never buy more as it falls unless that was planned in advance.

Worked example: an oversold bounce

  1. An index ETF is trading above its 200-day moving average.
  2. A three-day fall takes it from £420 to £398, and the 14-day RSI drops to 27.
  3. The next day it closes at £401 and RSI ticks back up to 32. You buy at £401.
  4. Your stop goes below the recent low, at £395: £6 of risk.
  5. Four days later RSI is back above 55 and you sell at £412. You made £11: about +1.8R.

Pros and cons of RSI mean reversion

Strengths

  • Clear, testable rules.
  • Often wins frequently when combined with a trend filter.
  • Short trades free up your money quickly.

Weaknesses

  • Occasional large losses when a dip keeps falling.
  • Does badly against strong one-way moves.
  • Small profits per trade, so costs matter a lot.

Key terms

RSI
Relative Strength Index: a 0–100 score of recent rises against recent falls.
Overbought / oversold
Usually RSI above 70 or below 30: the recent move has been unusually strong.
Mean reversion
The tendency of stretched prices to move back toward their average.
Time stop
Getting out after a set number of candles if the expected move hasn’t happened.
Divergence
Price makes a new low (or high) but RSI doesn’t.

Sources

Numbers in the lesson, like 1, point to these sources.

  1. Wilder, J. W. (1978), New Concepts in Technical Trading Systems. Book.
  2. Relative Strength Index (RSI). StockCharts ChartSchool.
  3. Connors, L. and Alvarez, C. (2008), Short Term Trading Strategies That Work. Book.

Lesson complete

You have reached the end of the lesson. Now test what you learned with the five-level quiz.

Start the quiz

Quiz zone

Test yourself: RSI Oversold Reversion quiz

Five levels, from the basics to expert judgment. Clear each level to unlock the next.

  1. Level 1: Foundations. Recognise the strategy and its vocabulary.
  2. Level 2: Mechanics. Know how the signals and rules work, and why.
  3. Level 3: Application. Apply the rules to realistic chart situations.
  4. Level 4: Numbers & risk. Size, measure and manage the trade with real calculations.
  5. Level 5: Mastery. Judge edge cases, failure modes and market conditions.

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See all 30 questions in this quiz

The questions only. Answers and explanations appear when you take the quiz above.

Level 1: Know the RSI basics

  1. What range does the RSI move within?

    • There’s no limit
    • 0 to 100
    • −100 to +100
    • 0 to 1

  2. An RSI reading below which level is usually called oversold?

    • 90
    • 70
    • 50
    • 30

  3. How many candles does the standard RSI use?

    • 200
    • 50
    • 14
    • 2

  4. True or false: an RSI of 80 means the price is certain to fall soon.

    True or false?

Level 2: Understand how RSI works

  1. What does the RSI compare?

    • Today’s price with last year’s
    • One share with another
    • Buying volume with selling volume
    • The size of recent rises with the size of recent falls

  2. Why only buy when price is above its 200-day moving average?

    • It means the share is cheap
    • The 200-day average makes RSI more accurate
    • Brokers require it
    • Dips in uptrends tend to bounce. In downtrends, oversold markets can keep falling

  3. Changing the RSI from 14 candles to 2 candles mostly…

    • has no effect
    • makes it swing to extremes more often, giving more signals
    • stops it reaching 30
    • makes it slower

  4. True or false: mean reversion strategies can win often but still have the odd large loss, so a stop or time stop is important.

    True or false?

  5. What does “overbought” really mean?

    • The recent rise has been unusually strong
    • The price is too expensive
    • Everyone has already bought
    • You must sell now

Level 3: Use the rules

  1. Price is above its 200-day average. RSI(14) drops to 26 after a sharp four-day fall. What is the disciplined way to buy?

    • Sell short
    • Wait for RSI to close back above 30, then buy
    • Wait for RSI to reach 70
    • Buy now at 26

  2. Price is below a falling 200-day average and RSI hits 22. What do the rules say?

    • No trade: the trend filter fails
    • Buy double
    • Buy: RSI is very oversold
    • Wait for RSI to reach 10, then buy

  3. A share in a strong uptrend has had RSI above 70 for three weeks. A trader keeps selling it short because it’s “overbought”. What is the mistake?

    • They should wait for RSI 100
    • There’s no mistake
    • RSI can stay high for a long time in strong trends. Overbought alone isn’t a reason to sell
    • They should use RSI(2) instead

  4. You bought on an oversold signal. Five days later price hasn’t bounced or hit your stop, and RSI sits at 35. Your rules include a 5-day time stop. What do you do?

    • Sell: the bounce hasn’t come in the time you expected
    • Hold until it bounces, however long it takes
    • Move your stop lower
    • Buy more

  5. Price is above its 200-day average and RSI(2) drops to 6. Under the Connors and Alvarez version, what is this?

    • A buy setup: RSI(2) below 10 in an uptrend
    • A sell signal
    • A death cross
    • Nothing: RSI(2) is never used

  6. In the Connors and Alvarez version, when do you sell?

    • When RSI(2) reaches 100
    • When price closes above its 5-day moving average
    • When price falls below the 200-day average
    • After one year

Level 4: Work out RSI and results

  1. Over 14 candles, the average gain is 1.5 and the average loss is 1.0. What is the RSI? (RS = gain ÷ loss, then RSI = 100 − 100 ÷ (1 + RS).)

    Type a number (RSI).

  2. The average gain is 0.5 and the average loss is 1.5. What is the RSI?

    Type a number (RSI).

  3. The average gain and the average loss are the same size. What is the RSI?

    Type a number (RSI).

  4. You buy at £401 with a stop at £395. How much are you risking on each share, in pounds?

    Type a number (a share).

  5. Your account is £12,000 and you risk 1%. You buy at £401 with a stop at £395. How many shares so that hitting your stop loses only 1%?

    Type a number (shares).

  6. You buy at £401 with a stop at £395 and sell at £412. What is the result in R? Give two decimal places.

    Type a number (R).

  7. A strategy wins 70% of trades, averaging +0.8R. Losses average −1.5R. What is its expectancy, in R a trade?

    Type a number (R).

Level 5: Handle the tricky cases

  1. Price makes a lower low, but RSI makes a higher low. What is this called, and what does it suggest?

    • Bullish divergence: selling may be losing strength
    • Overbought: sell short
    • Nothing important
    • A death cross: sell everything

  2. A backtest shows a 75% win rate, but the worst trade lost 9R because there was no stop. What is the biggest worry?

    • The win rate is too low
    • Nothing: 75% is great
    • One rare large loss can wipe out many wins. Add a stop or a size limit
    • The test used too much data

  3. When is RSI mean reversion most likely to struggle?

    • In a calm, rising market
    • On a quiet Monday
    • During a fast one-way move, such as a crash
    • When RSI is near 50

  4. Why might buying sharp dips be safer in a broad index than in one small company?

    • Indexes never fall
    • An index spreads risk across many companies. One company can fall for a real reason and keep falling
    • Small companies don’t have an RSI
    • Indexes always bounce in one day

  5. Your RSI trade is falling towards your stop. Should you buy more to lower your average price?

    • Yes, but only with leverage
    • Yes, always
    • Only if that was planned in advance. Otherwise no
    • Yes, and remove the stop

  6. Why do the rules say to keep position sizes modest with this strategy?

    • Small sizes win more often
    • Brokers limit RSI trades
    • Losses can be bigger than wins
    • Wins are always huge

  7. A strongly rising market has RSI at 78. Which is the most sensible view?

    • RSI is broken
    • The rise is strong. It isn’t a reason by itself to sell or go short
    • Buy because RSI is high
    • Sell short now

  8. Which pair of tools best protects a mean reversion trade?

    • A hard stop below the recent low and a time stop
    • A target only
    • A bigger position
    • No stop, because dips always bounce

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