What is the RSI Indicator? How to Identify Overbought and Oversold Conditions with it?

In the realm of modern financial market analysis, whether it’s the fast-paced forex market, the highly volatile cryptocurrency market, or traditional stock indices, technical analysis always plays an indispensable role. Among the many technical indicators, the Relative Strength Index (RSI) is undoubtedly one of the most classic and widely used tools. Proposed decades ago by a master of technical analysis, its design concept has stood the test of time and remains a core indicator for measuring market momentum used by professional traders and institutional algorithmic trading systems worldwide.

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The essence of the RSI indicator can be vividly understood as the market’s “momentum speedometer.” It doesn’t just measure price rises and falls; it precisely quantifies the speed and magnitude of price changes, thereby providing traders with a visual reference to monitor the intrinsic strength of a specific market in its current and historical context.
 

What are the Origins and Core Concepts of the RSI Indicator?

To truly master an analytical tool, a trader must trace its origins, understand its creator’s original intent, and its precise mechanical design. Only then can it be applied flexibly in the complex and ever-changing market, rather than being used rigidly.

The Inventor of RSI

The creation of the Relative Strength Index (RSI) is credited to the American technical analysis giant, J. Welles Wilder Jr.. Mr. Wilder had a unique background; he was initially a mechanical engineer who later moved into real estate development, but ultimately left an immortal legacy in the field of financial technical analysis. His engineering background gave him a systematic and logical way of thinking, allowing him to solve seemingly chaotic market problems with rigorous engineering methods.

In 1978, Wilder published his groundbreaking book, “New Concepts in Technical Trading Systems.” In this book, he not only introduced RSI but also launched several other indicators that are still considered cornerstones of technical analysis, including the Average True Range (ATR), Parabolic SAR, and the Average Directional Index (ADX). Wilder’s contributions quickly gained high recognition in the industry, and in the 1980s, he was acclaimed as the most outstanding technical trading expert of his time by authoritative financial media such as Forbes and Barron’s.
Wilder was not creating a single “magic indicator,” but rather building a complete analysis system. The indicators he designed, such as RSI, ATR, and ADX, were each intended to solve different market problems—RSI measures momentum, ATR measures volatility, and ADX measures trend strength. This means that from its inception, RSI was not an isolated tool but a component of an entire analytical framework. This provides strong theoretical support for our later discussion on combining RSI with other indicators, as this combined use is precisely in line with the inventor’s original systematic design philosophy.
 

How Does RSI Quantify the Market’s Relative Strength?

The core function of the RSI indicator is to quantify the relative strength of the market over a specific period using a value that ranges between 0 and 100. Its calculation logic compares the average magnitude of recent price gains to the average magnitude of recent price losses, thereby determining the balance of power between bulls and bears.

The basic formula is as follows:
RSI = 100 – 100 / ( 1 + RS )
Where, RS (Relative Strength) is calculated as:
RS = Average Gain / Average Loss​
The entire calculation process can be broken down into the following steps:

1. Set the Period: First, a calculation period must be chosen. Wilder’s recommended standard period is 14. This means the indicator will analyze data from the past 14 trading periods (e.g., 14 days, 14 hours, etc.).
2. Calculate Average Gains and Losses: Within the selected 14 periods, sum up all price increases on up days and divide by 14 to get the “Average Gain.” Similarly, sum up all price decreases (using their absolute values) on down days and divide by 14 to get the “Average Loss.”
3. Calculate Relative Strength (RS): Divide the “Average Gain” by the “Average Loss” to get the RS value.
4. Calculate RSI: Substitute the obtained RS value into the final RSI formula to get a value between 0 and 100.

Here, an often-overlooked but crucial technical detail is that professional RSI calculations do not use a simple arithmetic mean. Instead, they employ Wilder’s specific Smoothed Moving Average, which is a variant of the Exponential Moving Average (EMA). Unlike a simple moving average that gives equal weight to all data within the period, an exponential smoothed average gives higher weight to more recent price data.

Related article: What is a Moving Average? How Does It Reveal Market Trends?

This seemingly minor difference has a practical impact on traders. By using exponential smoothing, Wilder’s RSI indicator is more sensitive to the latest price changes and reacts faster. This means traders using professional-grade trading platforms may receive signals earlier than those on platforms that use simple average calculations. This fractional difference in timing, in the fast-paced world of trading, can directly affect the timing of entry and exit, and ultimately determine the success or failure of a trade. This also highlights the importance for professional traders to “master their tools”—to know not only what they do, but also how they work.
 

How to Interpret Basic RSI Indicator Signals?

After understanding the construction principles and calculation core of the RSI indicator, we can confidently explore how to interpret the market messages it conveys. From the widely known overbought and oversold zones to the centerline that marks the bull-bear divide, these basic signals form the cornerstone of RSI analysis.
 

Overbought and Oversold: What is the RSI’s 70/30 Rule?

The most basic and widely known use of the RSI indicator is to identify Overbought and Oversold market conditions. These are defined by two key levels originally set by Wilder:

• RSI above 70: When the RSI value enters the area above 70, it is traditionally considered overbought. This does not mean the price will immediately fall, but rather that the market’s buying momentum may have reached an extreme or unsustainable level, increasing the risk of a price correction or consolidation.
• RSI below 30: When the RSI value falls into the area below 30, it is considered oversold. Similarly, this suggests that the market’s selling momentum may be too strong, selling pressure is immense, the price may be undervalued, and there is a possibility of a rebound.

However, the difference between professional traders and market novices lies in the depth of their understanding of these two zones. Novices often equate “overbought” with “sell immediately” and “oversold” with “buy immediately,” which is an extremely dangerous misconception. In reality, overbought and oversold are warning signals, not direct trading commands.

In a strong trending market, the RSI indicator can exhibit a phenomenon known as “saturation.” For example, in a fierce bull market, the RSI might remain in the overbought zone above 70 or even 80 for an extended period, while the price continues to make new highs. In this situation, the overbought signal is not a sign of an impending reversal but rather a powerful confirmation of the trend’s strength. If a trader hastily goes short based on this overbought signal, they would be trading against the trend and likely incur unnecessary losses. Therefore, the interpretation of the 70/30 rule must be combined with the current market environment: in a ranging market, they are relatively reliable reversal references; in a trending market, they are more of a reflection of trend strength.

Furthermore, some traders adjust the overbought and oversold thresholds to 80 and 20 to filter out some market noise and seek more extreme market sentiment signals, depending on the volatility of different assets.

The 50 Centerline: The Key RSI Level for Bull-Bear Division

If 70 and 30 are the extreme sentiment alarm lines, then the 50 centerline is the watershed for judging the balance and shift of power between bulls and bears. Its meaning is extremely intuitive:

• RSI consistently above 50: This indicates that within the calculation period, the average gain is greater than the average loss, meaning the market is dominated by bulls and is in an overall bullish atmosphere.
• RSI consistently below 50: This means the average loss is greater than the average gain, the market is controlled by bears, and the overall sentiment is bearish.
• RSI hovering around 50: This suggests that bulls and bears are evenly matched, and the market may be in a consolidation phase without a clear trend.

The value of the 50 centerline extends far beyond this. In a mature trend, it also acts as dynamic support and resistance. Many experienced traders have found that in an established uptrend, when the price pulls back, the RSI indicator often finds support in the 40 to 50 range before rising again. In a downtrend, when the price rallies, the RSI often encounters resistance in the 50 to 60 range before turning down.
This observation leads to a more advanced application technique: traders can apply trendline analysis directly to the RSI indicator chart. For example, by connecting two or more lows on the RSI chart to draw an uptrend line. When the RSI indicator breaks below this trendline, or breaks below the 50 centerline, it often signals that the dominant market trend may be changing, serving as a leading warning signal compared to waiting for the price to break its trendline.
 

How to Set Up and Apply the RSI Indicator in a Trading Platform?

Applying the RSI indicator to your trading chart is a very standardized process. Whether you are using MT4, MT5, or other mainstream trading platforms, the basic steps are largely the same.
Generally, you can find it in the “Insert” or “Indicators List” menu of the trading platform, usually categorized under “Oscillators.” After clicking on “Relative Strength Index,” a parameter settings window will pop up.

In this window, you can customize several core parameters:

• Period/Length: This is the most important parameter, defining the time length covered by the RSI calculation. The default value is usually 14, which you can adjust based on your trading style and market characteristics, as will be discussed in later sections.
• Apply to/Source: This option determines the price type on which the RSI calculation is based. In the vast majority of cases, the default “Close” price should be maintained, as this is the price used in Wilder’s original design.
• Levels: Here you can set or modify the overbought and oversold levels, which default to 70 and 30.

Once configured, the RSI indicator will appear in a separate window below the main price chart. For users of CashbackIsland, we understand that reliable trading tools are the foundation of success. Therefore, our recommended partner brokers all provide professional-grade trading platforms like MT4 and MT5, ensuring you can use core analytical tools like RSI stably and efficiently. Combined with the professional calculation tools and real-time market intelligence provided on the CashbackIsland website, you can build a complete and powerful trading decision-making ecosystem.

What Are the Advanced Ways to Interpret the RSI Indicator Beyond the Basics?

Once you have mastered the basic use of RSI, you can begin to explore its more subtle and powerful advanced interpretation methods. Beyond the traditional 70/30 rule, the true analytical potential of RSI lies in the more nuanced and complex signals. These advanced techniques are what separate professional analysts from ordinary traders, helping you to gain earlier insight into potential market turning points.
 

RSI Divergence

RSI Divergence is one of the most powerful leading signals in technical analysis. It occurs when there is a clear contradiction between the movement of the asset’s price and the movement of the RSI indicator. This inconsistency often indicates that the momentum of the current trend is waning and the market may be about to experience a reversal.

Divergence is mainly divided into two basic types:

• Bearish Divergence: This occurs when the asset’s price makes a new high (Higher High), but the RSI indicator fails to make a new high, instead forming a lower high (Lower High). This pattern is like a car going uphill; although the speedometer (price) shows it’s still moving forward, the engine RPM (RSI momentum) has started to drop. This is a strong warning that the upward momentum is weakening, a market top may be forming, and there is a risk of a trend reversal to the downside.
• Bullish Divergence: The opposite of bearish divergence, this occurs when the asset’s price makes a new low (Lower Low), but the RSI indicator refuses to follow, instead forming a higher low (Higher Low). This suggests that although the price is still falling, the selling pressure (momentum) has started to weaken, buying strength is quietly accumulating, a market bottom may be near, and there is a possibility of a trend reversal to the upside.

However, professional traders are extremely cautious when using divergence signals. Divergence is a “warning tool,” not a “timing tool.” After a divergence appears, the market may still continue in its original trend for some time, even making several new highs or lows. Therefore, blindly entering a trade immediately after seeing a divergence is extremely risky. The wise approach is to treat divergence as a signal to raise your guard, and then patiently wait for confirmation from the price action itself, such as waiting for the price to clearly break a key uptrend line or for a clear bearish candlestick reversal pattern to appear before considering executing a trade. This step of combining confirmation is key to turning divergence signals into high-probability trading strategies.

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In addition to the two basic types of divergence, there is also a pattern known as “hidden divergence,” which is usually considered a trend continuation signal rather than a reversal signal. For example, in an uptrend, if the price pulls back to form a higher low while the RSI makes a lower low, this is called a hidden bullish divergence, suggesting the trend is likely to resume its upward path after the pullback.

Failure Swings

Failure Swings are a unique and powerful reversal signal from the RSI indicator. What makes them unique is that their identification is based entirely on the RSI indicator’s own pattern, without reference to price action, making it a purer momentum signal. The core logic of a failure swing is that the momentum itself “fails” to re-enter the extreme zone, indicating that the force driving the previous trend has been exhausted.

Failure swings also come in bullish and bearish forms, each containing four distinct steps:

• Bullish Failure Swing:
  1. The RSI indicator falls below 30, entering the oversold zone.
  2. The RSI rallies back above 30, forming a short-term trough.
  3. The RSI pulls back again but fails to break below 30, forming a higher low above 30.
  4. Subsequently, the RSI breaks above the previous high formed during the rally in step 2. This breakout is considered a confirmation signal for a bullish reversal.
• Bearish Failure Swing:
  1. The RSI indicator rises above 70, entering the overbought zone.
  2. The RSI falls back below 70, forming a short-term peak.
  3. The RSI rallies again but fails to rise above 70, forming a lower high below 70.
  4. Subsequently, the RSI breaks below the previous low formed during the pullback in step 2. This breakdown is considered a confirmation signal for a bearish reversal.

The strength of the failure swing signal lies in its ability to capture the key moment of momentum shift. In a bullish failure swing, for example, the RSI’s failure to break below 30 in step three shows the exhaustion of selling pressure, while the breakout above the previous high in step four signifies that buying pressure has officially taken control of the market. Mastering this technique requires traders to perform detailed pattern analysis on the RSI chart itself, which is an important step from basic application to advanced analysis.

Andrew Cardwell’s Revolutionary Perspective: Redefining RSI for Trend Confirmation

Building on Wilder’s foundation, analyst Andrew Cardwell extended the interpretation of RSI in a revolutionary way, elevating it from an indicator primarily used for reversals to a sophisticated trend confirmation tool. Cardwell’s theories, in some ways, even subvert traditional concepts, providing professional traders with a deeper level of analytical perspective.

Cardwell’s core ideas include the following:

• Range Shifts: Cardwell observed that the RSI operates within different ranges during different market trends. In a healthy uptrend, the RSI typically fluctuates between 40 and 80. In a clear downtrend, the RSI tends to operate between 20 and 60. Therefore, when the RSI’s main activity range shifts from 40-80 to 20-60, this in itself is a strong signal that the market’s primary trend may have shifted from bullish to bearish.
• Redefining Divergence: This is Cardwell’s most subversive idea. He argued that traditional bearish divergence (price makes a new high, RSI fails to make a new high) is actually a characteristic of an uptrend. It usually only leads to a brief price correction, not a trend reversal, and thus serves as a confirmation of the uptrend. Similarly, bullish divergence is a characteristic of a downtrend, confirming the continuation of the downtrend.
• Positive & Negative Reversals: These concepts are the essence of Cardwell’s theory. They are the opposite of traditional divergence and are extremely powerful trend continuation signals.
  • Positive Reversal: Occurs only in an uptrend. This happens when the price forms a higher low (Higher Low) during a pullback, while the RSI indicator makes a lower low (Lower Low). This indicates that despite a sharper drop in short-term momentum (RSI), the actual price refuses to follow, showing extremely strong underlying buying support and signaling that the uptrend is about to resume.
  • Negative Reversal: Occurs only in a downtrend. This happens when the price forms a lower high (Lower High) during a rally, while the RSI indicator makes a higher high (Higher High). This shows that although the short-term rally momentum appears strong, the price fails to break the previous high, indicating heavy underlying selling pressure and signaling that the downtrend will continue.

Cardwell’s theory shifts the focus of analysis from simply looking for reversals to confirming and following the trend, providing traders with a more robust trend-following framework. It perfectly explains why traditional divergence signals often “fail” in strong trends—because according to Cardwell’s theory, they were never reversal signals to begin with. Mastering these advanced concepts will undoubtedly elevate your RSI analysis skills to a new professional level.

What Limitations and Pitfalls Must Traders Be Aware of When Using the RSI Indicator?

No technical indicator is a holy grail, and RSI is no exception. A mature analyst must not only be adept at leveraging a tool’s strengths but also have a deep understanding of its inherent limitations. Only then can one avoid pitfalls and make more objective and rational decisions in actual trading. This section will focus on several key issues to be vigilant about when using RSI.

The Phenomenon of RSI Saturation in Trending Markets

The main limitation of the RSI indicator is the phenomenon of saturation that it exhibits in strong, one-sided trending markets. Saturation refers to the situation where, during a sustained and sharp upward or downward trend, the RSI indicator will remain in the overbought zone (above 70) or oversold zone (below 30) for an extended period, thereby losing its sensitivity to price changes.

In such cases, if a trader stubbornly adheres to the traditional counter-trend trading mindset of “sell when overbought, buy when oversold,” it will generate a series of false signals, leading to significant losses. For example, when an asset enters a major bull run, its RSI value may stay above 80 for weeks or even months, while the price continues to climb. At this point, every overbought signal becomes a trap for short-sellers.
However, from a deeper perspective, RSI saturation is not a “flaw” of the indicator but rather a “characteristic.” It is, in fact, the RSI indicator faithfully reflecting the existence of an extremely powerful one-sided momentum in the market. Therefore, the core issue is not that the indicator has failed, but that the trader is misinterpreting the signal.

When professional traders observe RSI saturation, they immediately recognize that the market is in a strong trend mode. At this point, they will proactively switch their analytical framework: they stop looking for reversal opportunities and start applying trend-following strategies. They will use Andrew Cardwell’s theories, viewing the sustained overbought condition as a confirmation of the bull market, and look for opportunities to buy with the trend during price pullbacks when the RSI tests the 50 centerline or the 40 support level. This ability to judge the market state based on the RSI’s own behavior and flexibly adjust strategies is the essence of professional trading.

How to Adjust RSI Based on Market Characteristics and Trading Style?

The default period for the RSI indicator is 14, which is a balanced choice that performs well in most markets and timeframes. However, the “optimal” parameter setting is not set in stone; it needs to be flexibly adjusted based on the trader’s personal style, trading timeframe, and the volatility characteristics of the target asset. This is an art that requires experience and testing.

• Adjusting the Period:
  • Shorter periods (e.g., 5, 7, 9): Will make the RSI indicator more sensitive to price changes, allowing it to capture short-term momentum changes more quickly. This setting is often favored by day traders and scalpers. However, the trade-off is that signals become more frequent, and the number of false signals (market noise) also increases significantly.
  • Longer periods (e.g., 21, 25, 30): Will make the RSI curve smoother and less sensitive to short-term price fluctuations. This filters out a significant amount of market noise, producing fewer but generally more reliable trading signals. This setting is more suitable for swing traders and position traders, helping them focus on capturing major medium to long-term trends.
• Adjusting Overbought/Oversold Levels:
  • Besides adjusting the period, modifying the overbought/oversold thresholds is another common optimization method. In highly volatile markets (like some cryptocurrencies) or very strong trending markets, the standard 70/30 levels may be hit too frequently. In such cases, widening the thresholds to 80/20 or even 90/10 can help traders focus only on the most extreme moments of sentiment, thereby improving signal quality.
  • Conversely, in low-volatility, ranging markets, traders may find it difficult for the price to reach 70/30. In this situation, the thresholds can be narrowed, for example, to 65/35, to capture more trading opportunities.
  • Incorporating Cardwell’s theory, in a confirmed uptrend, a trader might adjust the analysis range to 80/40; while in a downtrend, a 60/20 range might be used for analysis.

How to Combine the RSI Indicator with Other Analytical Tools to Build a Multi-dimensional Analysis Framework?

While RSI is powerful, any single indicator has its blind spots. Professional trading decisions are never based on isolated signals but are built on the foundation of multiple analytical tools confirming each other and creating confluence. A multi-dimensional analysis framework can significantly filter out false signals and improve the win rate and reliability of trades.

Synergy between RSI and Moving Averages

Moving Averages (MA) are one of the most intuitive and effective tools for determining the market’s primary trend direction. The core idea of combining RSI with moving averages is to use the moving average to define the macro trend and then use RSI to find precise entry points in the direction of that trend.

The application of this combined strategy is very straightforward: first, add a long-term moving average to the chart, such as a 50-period or 200-period Exponential Moving Average (EMA). This line will serve as a “filter” for the bull/bear trend.

• When the price is above the long-term moving average, the market is defined as being in an uptrend. In this case, traders should only focus on bullish signals from the RSI, such as RSI entering the oversold zone, RSI bouncing off the 40-50 support area, or a bullish divergence. All bearish RSI signals should be ignored, as they are likely false signals against the trend.
• When the price is below the long-term moving average, the market is defined as being in a downtrend. At this point, traders should only focus on bearish signals from the RSI, such as RSI entering the overbought zone, RSI being rejected from the 50-60 resistance area, or a bearish divergence.

In this way, the moving average provides directional guidance for RSI’s momentum signals, greatly filtering out low-probability counter-trend trading opportunities and transforming RSI from a simple oscillator into a powerful trend-following entry tool.

Dual Momentum Confirmation with RSI and MACD

The Moving Average Convergence Divergence (MACD) is another popular momentum indicator that measures trend changes by calculating the difference between two exponential moving averages of different speeds. Since RSI and MACD have different underlying logic for calculating momentum, they can form an excellent complementary and validating relationship.
The core strategy of combining them is dual confirmation. When one indicator gives a signal, waiting for a corresponding confirmation signal from the other can significantly increase the reliability of the trade. A classic application example is as follows:

• Buy Signal: Wait for the RSI to enter the oversold zone (e.g., below 30), which indicates the market may be oversold. But don’t rush to enter. Instead, continue to watch the MACD indicator. When the MACD line (DIF) crosses above its signal line from below, forming a “golden cross,” this is considered a confirmation signal that the trend may be turning. The combination of an oversold RSI and a MACD golden cross constitutes a high-strength buy signal.
• Sell Signal: Wait for the RSI to enter the overbought zone (e.g., above 70), warning that the market may be overheated. Then, wait for the MACD line to cross below its signal line from above, forming a “death cross.” This combination signal suggests that the upward momentum may be exhausted and presents a potential selling or shorting opportunity.

Since MACD is generally considered a relatively slower, smoother indicator, using it to confirm RSI signals may sacrifice some of the earliest entry opportunities, but in return, it provides higher signal accuracy and effective filtering of false signals.

Volatility Analysis with RSI and Bollinger Bands

Bollinger Bands are an indicator that measures market volatility, consisting of a middle band (usually a 20-period simple moving average) and two standard deviation bands above and below it. The bands expand when market volatility increases and contract when the market is calm.

Related article: What Are Bollinger Bands? An Indispensable Volatility Guide for Your Trading Toolbox

Combining RSI with Bollinger Bands is a classic strategy that merges momentum analysis (RSI) with volatility analysis (BB). This strategy is particularly effective in ranging markets. The basic logic is that when the price simultaneously reaches an extreme of volatility (the upper or lower Bollinger Band) and an extreme of momentum (RSI overbought or oversold), the probability of a reversal increases significantly.

The specific trading signals are as follows:

• Buy Signal: When the price touches or briefly dips below the lower Bollinger Band, and at the same time, the RSI indicator shows oversold (below 30). This combination suggests that the price is not only statistically far from its mean, but the downward momentum has also reached its limit, presenting a potential buying opportunity.
• Sell Signal: When the price touches or briefly breaks above the upper Bollinger Band, and at the same time, the RSI indicator shows overbought (above 70). This implies that the price rally may be unsustainable in terms of both volatility and momentum, presenting a potential selling opportunity.

It is important to note that in a strong trending market, the price may “walk the band,” and this reversal strategy will fail. Therefore, before using this combined strategy, it is best to first determine if the market is in a ranging state using other tools (such as a long-term moving average or the ADX indicator).

Conclusion: The Core Value and Practical Wisdom of the RSI Indicator

The true power of RSI does not come from its isolated use, but from a deep understanding of the market environment and the synergistic confirmation of multiple analytical tools. A professional trader must be able to determine whether the market is in a trending or ranging mode based on the RSI’s behavior (e.g., whether saturation is occurring) and switch their trading strategy accordingly—looking for reversals in ranging markets and following the trend in trending markets.

More importantly, combining RSI with tools like moving averages, MACD, and Bollinger Bands to build a multi-dimensional analysis framework for mutual verification is key to filtering out market noise and improving the quality of decision-making. This requires traders not only to be proficient in using the tools but also to have insight into the mathematical principles and design philosophies behind them.

On your trading journey, CashbackIsland is committed to being your indispensable professional partner. Our purpose extends far beyond being a platform for financial trading rebates. We are a comprehensive resource center aimed at empowering our users in every way by providing in-depth, professional educational content like this, combined with convenient calculation tools and timely market intelligence on our website. We believe that by helping you master powerful analytical tools like RSI, you will be able to navigate the global financial markets with more confidence, rationality, and efficiency, ultimately achieving your trading goals.

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Frequently Asked Questions

Q1. What is the best parameter setting for the RSI indicator?

While the default 14-period setting is widely used and fairly balanced, there is no single “best” setting. The optimal parameter depends on your trading style and market volatility.

Q2. Can I trade using only the RSI indicator?

It is not recommended to rely solely on the RSI indicator for trading. Although RSI is powerful, like any single indicator, it has its limitations, especially in strong trending markets where it can generate false signals. Professional traders typically combine RSI with other indicators like moving averages, MACD, or Bollinger Bands to mutually confirm signals, thereby building a more robust trading strategy.

 
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