Indicators 101: moving averages and RSI
Learning objectives
Explain what an indicator is and why none of them contains information that isn't already in the price
Describe what a moving average shows and the unavoidable trade-off in choosing its period
Interpret RSI correctly, including why an overbought reading is not a sell signal
What is an indicator?
An indicator is a calculation performed on price data and displayed on your chart.
That's the whole definition, and one consequence follows from it that governs everything else in this lesson:
An indicator contains no information that isn't already in the price.
It reorganises what's already there so a particular quality becomes easier to see. That's genuinely useful, and it's also the ceiling. No calculation can extract information the underlying data doesn't hold.
Which is why the warning from our technical analysis lesson bears repeating. Stacking six indicators on a chart doesn't produce six opinions confirming one another. It produces one opinion, restated six times, and the resulting confidence is manufactured.
Two categories
Trend-following indicators smooth price to show direction. Moving averages are the archetype. They are, by design, always behind the market. That isn't a defect to be tuned out, it's what smoothing means.
Oscillators measure the speed or extent of movement, usually on a scale from 0 to 100. RSI is the archetype.
Neither predicts. One describes what has been happening to direction, the other describes how fast it happened.
Moving averages
A moving average is the average closing price over the last N periods, recalculated as each new period completes.
A simple moving average (SMA) weights every period equally. An exponential moving average (EMA) weights recent prices more heavily, so it responds faster to new movement and turns sooner. Neither is better. They answer slightly different questions.
The trade-off you can't escape
Choosing the period is choosing between two things you'd both like to have.
- A short period, say 20. Responsive. Follows price closely. Turns quickly when direction genuinely changes, and also turns quickly when it doesn't, giving you many false signals.
- A long period, say 200. Smooth. Describes the larger direction reliably. Very slow to reflect a genuine change, so by the time it turns, a substantial part of the move has happened.
There is no correct number. Anyone offering you the optimal setting is selling something. You are choosing responsiveness or reliability, and every setting buys one with the other.
What traders actually use them for
As a direction filter. Only take long trades while price is above the 200-period average, for instance. This doesn't tell you when to enter. It removes a category of trade from consideration, which is a legitimate use.
As a reference level. Price often behaves differently around a widely watched average. It gives you somewhere to place your stop loss and take profit levels.
Crossovers. A shorter average crossing a longer one. Popular, and worth being honest about.
A crossover is a lagging confirmation by definition, since both averages have to move before they can cross. In sustained trends this works acceptably. In ranging conditions it produces whipsaws: price crosses back and forth, generating a series of small losses in both directions. That isn't a settings problem you can optimise away, it's inherent to the tool, and any approach built on crossovers alone will have long unprofitable stretches when conditions don't suit it.
RSI
The Relative Strength Index compares the size of recent gains to the size of recent losses over a set number of periods, and scales the result from 0 to 100. Fourteen periods is the common default.
Conventionally, readings above 70 are labelled overbought and readings below 30 oversold.
Overbought does not mean sell.
It means price has risen strongly and quickly relative to its recent behaviour. That is a description of what has happened, not an instruction about what to do.
In a strong trend, RSI can sit above 70 for weeks while price keeps rising. A trader who sells every reading above 70 during a trend will lose repeatedly, and won't be doing anything wrong except believing the label. The words "overbought" and "oversold" have caused more retail losses than almost any other pair of words in trading.
What RSI is actually useful for
Context. Is this move stretched compared with how this instrument normally behaves? A reading of 78 tells you the recent move has been unusually fast. Fast moves sometimes continue and sometimes pause, and knowing you're in one is worth something even though it doesn't tell you which.
Divergence. Price makes a new high but RSI makes a lower high, suggesting the second push had less momentum behind it than the first.
Honest caveat, because divergence gets oversold as a concept: it can persist for a very long time before anything happens, and frequently nothing happens at all. Divergence is a reason to pay closer attention. It is not a reason to enter a trade by itself.
Using indicators (without being used by them)
Five rules that will keep you out of most of the trouble.
1. Two at most, measuring different things. One trend indicator and one oscillator tell you two things. Two oscillators tell you one thing twice.
2. Understand the calculation. If you can't roughly describe what an indicator computes, you can't know the conditions in which it breaks. That knowledge is the whole value.
3. Price supplies the levels; indicators supply the context. Your stop and target come from structure. Indicators help you decide whether the setup is worth taking.
4. Know the failure condition of each. This is the single most useful thing in the lesson: moving averages fail in ranging markets, and oscillators fail in trending ones. Each tool's weakness is the other's condition. Recognising which environment you're in matters far more than any setting you'll ever adjust.
5. Never let an indicator override your risk rules. No reading justifies widening a stop, increasing size beyond your calculation, or holding past your invalidation level. The entire Risk Management course outranks anything on this list.
Key takeaways
An indicator is a calculation on price data. It reorganises information already present and cannot add any, which is why more indicators don't mean more insight
Choosing a moving average period trades responsiveness against reliability. There's no correct setting, only a choice about which error you prefer
An overbought RSI reading means price has risen fast, not that it will fall. In a trend, RSI can stay above 70 for weeks
Moving averages fail in ranging markets and oscillators fail in trending ones. Knowing which condition you're in matters more than any setting