What Is the RSI Indicator? How to Identify Overbought and Oversold Conditions Using RSI?

In the realm of modern financial market analysis, whether it’s the fast-changing forex market, the highly volatile cryptocurrency space, or traditional stock indices, technical analysis 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. Developed by a renowned technical analyst decades ago, its design concept has stood the test of time and remains a core metric used by professional traders and institutional algorithmic trading systems worldwide to measure market momentum.

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At its core, the RSI can be thought of as the market’s “momentum speedometer”. It does not merely track price rises and falls, it precisely quantifies the speed and magnitude of price changes, giving traders a visual reference to monitor the inherent strength or weakness of a specific market in both its current and historical context.

What Is the Origin and Core Concept of the RSI Indicator?

To truly master an analytical tool, traders must trace it back to its origin, understanding the creator’s original intent and the precise mechanical design behind it. Only in this way, it can be applied flexibly in the ever-changing market, rather than being used in a rigid, formulaic manner.

The Inventor of the RSI

The Relative Strength Index (RSI) was created by a giant in the field of American technical analysis—J. Welles Wilder Jr.. Wilder’s career path was far from conventional, he began as a mechanical engineer, later moved into real estate development, and ultimately left an enduring legacy in the realm of financial technical analysis. His engineering background gave him a systematic and logical way of thinking, enabling him to approach seemingly chaotic market problems with the rigor and precision of engineering methodology.

In 1978, Wilder published his groundbreaking book “New Concepts in Technical Trading Systems”. In this work, he not only introduced the RSI but also unveiled several other indicators that remain cornerstones of technical analysis today, including the Average True Range (ATR), the Parabolic SAR, and the Average Directional Index (ADX). Wilder’s contributions quickly gained widespread recognition in the industry, and during the 1980s, he was hailed by leading financial media such as “Forbes” and “Barron’s” as one of the most outstanding technical trading experts of the era.

Wilder was not creating a single “magic indicator” but rather building a complete analytical system. The RSI, ATR, and ADX he designed were each intended to address different aspects of the market—RSI measures momentum, ATR measures volatility, and ADX measures trend strength. This means that from its inception, the RSI was never meant to be a standalone tool, but rather a component within a broader analytical framework. This also provides strong theoretical support for later strategies that combine RSI with other indicators, as such integration aligns perfectly with the inventor’s original philosophy of systematic design.

How Does RSI Quantify the Market’s Relative Strength?

The core function of the RSI indicator is to quantify a market’s relative strength over a specific period with a value ranging from 0 to 100. Its calculation logic compares the average magnitude of recent gains to the average magnitude of recent losses, thereby revealing the balance of power between buyers and sellers.

The basic calculation formula is as follows:

RSI = 100 – 100 / (1 + RS)

Among, RS (Relative Strength) represents relative strength, calculated as:

RS=AverageLoss/AverageGain​

The entire calculation process can be broken down into the following steps:

1. Set the Period: First, select a calculation period. Wilder’s recommended standard period is 14, meaning the indicator will analyze data from the past 14 trading periods (e.g., 14 days, 14 hours, etc.).
2. Calculate the Average Gain and Average Loss: Within the selected 14 periods, sum all the price increases and divide by 14 to get the “Average Gain”. Likewise, sum all the price decreases (using absolute values) and divide by 14 to get the “Average Loss”.
3. Calculate the Relative Strength (RS): Divide the “Average Gain” by the “Average Loss” to obtain the RS value.
4. Calculate the RSI: Substitute the RS value into the final RSI formula to obtain a number between 0 and 100.

Here, a frequently overlooked yet crucial technical detail is that professional RSI calculations do not use a simple arithmetic average, but rather employ Wilder’s unique Smoothed Moving Average, a variant of the Exponential Moving Average (EMA). Unlike a simple moving average, which assigns equal weight to all data points in the period, an exponential smoothing average gives greater weight to more recent price data.

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This seems like a minor difference,yet has a tangible impact for the traders. By adopting exponential smoothing, Wilder’s RSI indicator responds more sensitively to the latest price changes, allowing for faster reaction. This indicates that traders using professional-grade platforms may receive signals earlier than those on platforms that calculate using a simple average. In the fast-paced world of trading, such minute timing differences can directly affect entry and exit points, ultimately determining the success or failure of a trade. This underscores the importance for professional traders to “master their tools”, not only to know the way, but also understand the reason why.

How to Interpret Basic RSI Indicator Signals?

Once you understand the construction principles and calculation core of the RSI indicator, you can confidently explore how to interpret the market information it conveys. From the well-known overbought and oversold zones to the midline that marks the boundary between bullish and bearish forces, these fundamental signals form the cornerstone of RSI analysis.

Overbought and Oversold: What Is the 70/30 Rule of RSI Indicator?

​​The most basic and widely known use of the RSI indicator is to identify overbought and oversold market conditions. This is defined by two key levels originally set by Wilder:

• RSI above 70: When the RSI value moves into the area above 70, it is traditionally viewed as overbought. This does not mean prices will immediately fall, but it indicates that bullish momentum may have reached an extreme or unsustainable level, increasing the risk of a price pullback or consolidation.
• RSI below 30: When the RSI value falls into the area below 30, it is considered oversold. Similarly, this indicates that bearish momentum may be excessively strong, with heavy selling pressure. Prices may be undervalued, creating the potential for 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 merely warning signals, not direct trading instructions.

In a strong trending market, the RSI indicator may exhibit a phenomenon known as “passivation”. For example, in a powerful bull market, the RSI may remain in the overbought zone above 70, or even above 80, for an extended period while prices continue to hit new highs. In such cases, the overbought signal is not a sign of an impending reversal, but rather a strong confirmation of the trend’s momentum. If traders rush to short solely because they see an overbought signal, they are effectively going against the trend, which can easily lead to unnecessary losses. Therefore, interpreting the 70/30 rule must be done in conjunction with the current market environment: in a ranging market, these levels serve as more reliable reversal references; in a trending market, they are more a reflection of trend strength.

In addition, some traders, aiming to filter out part of the market noise, adjust the overbought and oversold thresholds to 80 and 20 based on the volatility characteristics of different assets, in search of more extreme market sentiment signals.

50 Midline: The Key RSI Level for Determining the Bull-Bear Divide

If 70 and 30 are the extreme alert lines for market sentiment, then the 50 midline is the watershed for assessing the balance and shift of bullish and bearish forces. Its meaning is straightforward:

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

The value of the 50 midline goes beyond this. In well-established trends, it can also act as a dynamic support or resistance level. Many experienced traders have observed that in a confirmed uptrend, when prices pull back, the RSI often finds support in the 40–50 range before rising again; whereas in a downtrend, when prices rebound, the RSI often encounters resistance in the 50–60 range before turning lower.

This observation leads to a more advanced application: traders can apply trendline analysis directly to the RSI chart. For example, on the RSI chart, connect two or more lows to draw an upward trendline. When the RSI breaks below this trendline or falls below the 50 midline, it often signals that the prevailing market trend may be shifting which is a leading warning indicator compared to simply waiting for the price to break its trendline.

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

Applying the RSI indicator to your trading chart is a highly standardized process. Whether you are using MT4, MT5, or another mainstream trading platform, the basic steps are largely the same.

In general, you can find it in the “Insert” or “Indicators List” menu of your trading platform, usually categorized under “Oscillators”. After clicking “Relative Strength Index”, a parameter settings window will pop up.

In this window, you can customize several key parameters:

• Period/Length: This is the most important parameter, defining the time span covered in the RSI calculation. The default is usually 14, and you can adjust it according to the trading style and market characteristics discussed in later sections.
• Apply to/Source: This option determines the type of price used in the RSI calculation. In most cases, it is best to keep the default “Close”, as this is the price used in Wilder’s original design.
• Levels: Here you can set or modify the overbought and oversold levels, which are preset to 70 and 30.

Once the setup is complete, the RSI indicator will appear in a separate window below the main price chart. For CashbackIsland users, we understand that reliable trading tools are the cornerstone of success. That’s why the partner brokers we recommend all offer professional-grade trading platforms such as MT4 and MT5, ensuring you can use core analysis tools like RSI with stability and efficiency. By combining these with the professional calculation tools and real-time market updates provided on the CashbackIsland website, you can build a complete and powerful trading decision-making ecosystem.

What Are the Advanced Interpretation Methods of the RSI Indicator?

Once you have mastered the basic applications of RSI, you can begin exploring its more nuanced and powerful advanced interpretations. Beyond the traditional 70/30 rule, the true analytical potential of RSI lies in the subtler and more complex signals it can reveal. These advanced techniques are what distinguish professional analysts from ordinary traders, enabling you to spot potential market turning points earlier.

RSI Divergence

RSI divergence is one of the most powerful leading signals in technical analysis. It occurs when the price movement of an asset and the movement of the RSI indicator show a clear discrepancy. This inconsistency often signals that the momentum of the current trend is weakening and that the market may be approaching a reversal.

There are two main basic types of divergence:

• Bearish Divergence: When the asset price makes a new high point (HigherHigh), but the RSI fails to follow with a new high and instead forms a lower point (LowerHigh). This pattern is like a car climbing a hill while the speedometer (price) shows it’s still moving forward, but the engine’s RPM (RSI momentum) is already dropping. This is a strong warning that bullish momentum is weakening, a market top may be forming, and the trend faces a risk of reversing downward.
• Bullish Divergence: The opposite of bearish divergence. When the asset price makes a new lower low point (LowerLow), but the RSI refuses to follow and instead forms a higher low point (HigherLow), it suggests that although the price is still falling, selling pressure (momentum) has begun to weaken, and buying power is quietly building. This may signal that the market bottom is close and the trend could reverse upward.

However, professional traders use divergence signals with great caution. Divergence is a “warning tool”, not a “timing tool”. Even after divergence appears, the market may continue in its original trend for some time, possibly making several new highs or lows. Therefore, blindly entering a trade immediately upon spotting divergence is extremely risky. The prudent approach is to treat divergence as a signal to heighten vigilance, then patiently wait for confirmation from price action itself, such as a clear break below a key upward trendline, or the appearance of a distinct bearish candlestick reversal pattern before considering a trade. This step of combining divergence with confirmation is the key to turning the divergence signal into a high-probability trading strategy.

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In addition to the two basic types of divergence mentioned above, there is also a pattern known as “hidden divergence”, which is generally regarded as a signal of trend continuation rather than reversal. 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 hidden bullish divergence, suggesting that the trend is likely to continue upward once the pullback ends.

Failure Swings

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

Failure swings are also divided into bullish and bearish forms, each consisting of four clear steps:

• Bullish Failure Swing:
  1. The RSI drops below 30, entering the oversold zone.
  2. The RSI rebounds above 30, forming a short-term trough.
  3. The RSI falls again but fails to break below 30, forming a higher low above 30 compared to the previous trough.
  4. The RSI then breaks above the prior high formed during the rebound in step 2. This breakout is regarded as a confirmation signal of a bullish reversal.
• Bearish Failure Swing:
  1. The RSI rises above 70, entering the overbought zone.
  2. The RSI falls back below 70, forming a short-term peak.
  3. The RSI rebounds again but fails to break above 70, forming a lower high below 70 compared to the previous peak.
  4. The RSI then breaks below the prior low formed during the pullback in step 2. This breakdown is regarded as a confirmation signal of a bearish reversal.

The power of the failure swing signal lies in its ability to capture the critical moment of momentum shift. In the case of a bullish failure swing, step three where the RSI fails to drop below 30 again indicates the exhaustion of selling pressure; while step four where the RSI breaks above the previous high signals that buying power has officially taken control of the market. Mastering this technique requires traders to conduct detailed pattern analysis on the RSI chart itself, making it an important step from basic application to advanced analysis.

Andrew Cardwell’s Revolutionary Perspective: Redefining RSI as a Trend Confirmation Tool

Building on Wilder’s foundation, analyst Andrew Cardwell expanded the interpretation of RSI in a revolutionary way, transforming it from a tool primarily used to spot reversals into a sophisticated trend confirmation indicator. In some respects, Cardwell’s theory even challenges traditional views, offering professional traders a deeper analytical perspective.

Cardwell’s core ideas include:

• Range Shifts: Cardwell observed that the RSI operates within different ranges depending on the market trend. In a healthy uptrend, the RSI typically fluctuates between 40 and 80; in a clear downtrend, it tends to remain between 20 and 60. Therefore, when the RSI’s primary operating range shifts from 40–80 to 20–60, this alone is a strong signal that the market’s main trend may have shifted from bullish to bearish.
• Redefining Divergence: This is Cardwell’s most disruptive idea. He argued that traditional bearish divergence (price makes a new high while RSI fails to make a new high) is actually a characteristic of an uptrend. It typically leads only to a brief price pullback rather than 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 two concepts are the essence of Cardwell’s theory, and they are the exact opposite of traditional divergence, serving as extremely powerful trend continuation signals.
  • Positive Reversal: Occurs only in an uptrend. When the price forms a higher low during a pullback, but the RSI makes a lower low, it indicates that although short-term momentum (RSI) has dropped more sharply, the actual price refuses to follow. This shows strong underlying buying support and signals that the uptrend is about to resume.
  • Negative Reversal: Occurs only in a downtrend. When the price forms a lower high during a rebound, but the RSI makes a higher high, it suggests that although short-term rebound momentum appears strong, the price fails to break the previous high. This reveals heavy underlying selling pressure and signals that the downtrend will likely continue.

Cardwell’s theory shifts the analytical focus from simply seeking reversals to confirming and following the trend, providing traders with a more robust framework for trend-following strategies. 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 an entirely new professional level.

What Limitations and Pitfalls Must Traders Watch Out for When Using the RSI Indicator?

No technical indicator is a foolproof holy grail, and the RSI is no exception. A seasoned analyst must not only know how to leverage the strengths of a tool, but also have a deep understanding of its inherent limitations. Only then can they avoid traps in real trading and make more objective, rational decisions. This section will focus on several key issues that must be carefully considered when using RSI.

RSI Passivation in Trending Markets

The primary limitation of the RSI indicator is the phenomenon of passivation in strong, one-sided trending markets. Passivation refers to situations where during a sustained and powerful uptrend or downtrend, the RSI remains in the overbought zone (above 70) or oversold zone (below 30) for an extended period, thus losing sensitivity to price changes.

In such cases, if traders continue to adhere to the traditional “sell when overbought, buy when oversold” contrarian mindset, it can lead to a series of false signals and significant losses. For example, when an asset enters a major rally phase, its RSI may stay above 80 for several weeks or even months while the price keeps climbing. In this scenario, every overbought signal becomes a trap for short sellers.

However, from a deeper perspective, RSI passivation is not a “flaw” in the indicator but rather a “feature”. In reality, it is RSI faithfully reflecting the presence of exceptionally strong one-sided momentum in the market. Therefore, the real issue lies not in the indicator malfunctioning, but in traders misinterpreting its signals.

When professional traders observe RSI passivation, they immediately recognize that the market is in a strong trend mode. At this point, they switch their analytical framework: abandoning the search for reversal opportunities and instead applying trend-following strategies. They use Andrew Cardwell’s theory, viewing a sustained overbought condition as confirmation of a bull market, and look for trend-aligned buying opportunities during price pullbacks, when RSI retests the 50 midline or the 40 support level. This ability to assess market conditions based on RSI’s own behavior and adjust strategies accordingly is the very essence of professional trading.

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

The default RSI period is 14, a balanced choice that works well across most markets and timeframes. However, the “optimal” parameter setting is not fixed, it should be adjusted flexibly according to the trader’s personal style, the trading timeframe, and the volatility characteristics of the target asset. This is an art that requires both experience and testing.

• Adjusting the Period:
  • Shorter periods (e.g., 5, 7, 9): Make the RSI more sensitive to price changes, allowing it to capture short-term momentum shifts more quickly. This setting is often favored by day traders and scalpers. The trade-off is that signals become more frequent, with a significant increase in false signals (market noise).
  • Longer periods (e.g., 21, 25, 30): Smooth the RSI curve, making it less sensitive to short-term price fluctuations. This filters out much of the market noise, generating fewer but generally more reliable trading signals. Such settings are better suited for swing traders and position traders, helping them focus on capturing medium- to long-term primary trends.
• Adjusting Overbought/Oversold Levels:
  • In addition to adjusting the period, modifying the overbought and oversold thresholds is a common optimization method. In highly volatile markets (such as certain cryptocurrencies) or in extremely strong trends, 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 sentiment moments, thereby improving signal quality.
  • Conversely, in low-volatility ranging markets, traders may find that prices rarely reach 70/30. In this situation, narrowing the thresholds such as using 65/35 can help capture more trading opportunities.
  • Incorporating Cardwell’s theory, traders can even adjust the analysis range to 80/40 in a confirmed uptrend, or to 60/20 in a downtrend.

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

Although the RSI is a powerful tool, every single indicator has its blind spots. Professional trading decisions never rely on isolated signals but built on multiple analytical tools that validate each other and create confluence. A multi-dimensional analysis framework can significantly filter out false signals, improving both the win rate and reliability of trades.

RSI and Moving Averages Synergy

Moving averages (MA) are one of the most straightforward and effective tools for determining the market’s primary trend direction. Combining RSI with moving averages is based on the core idea of: Using the moving average to define the macro trend, and then using RSI to pinpoint precise entry opportunities 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 serves as a “filter” for bullish and bearish trends.

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

In this way, the moving average provides directional guidance for RSI momentum signals, greatly filtering out low-probability countertrend trades and transforming the RSI from a simple oscillating indicator into a powerful trend-following entry tool.

RSI and MACD Dual Momentum Confirmation

The Moving Average Convergence Divergence (MACD) is another widely used momentum indicator that measures trend changes by calculating the difference between two exponential moving averages of different speeds. Since RSI and MACD use different underlying logic to calculate momentum, they can serve as excellent complements to and confirmations of each other.

The core strategy of combining the two is double confirmation. When one indicator generates a signal, waiting for the other to issue a corresponding confirmation signal can significantly improve trade reliability. A classic application example is as follows:

• Buy Signal: Wait for the RSI to enter the oversold zone (e.g., below 30), indicating that the market may be in an excessively sold-off state. Do not enter immediately, continue to monitor the MACD. When the MACD’s fast line (DIF) crosses above its slow line (signal line) from below, forming a “golden cross”, it serves as confirmation that the trend may be reversing. The simultaneous occurrence of an RSI oversold reading and a MACD golden cross forms 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 overheating. Then, wait for the MACD’s fast line to cross below its slow line, forming a “death cross”. This combination signal suggests that bullish momentum may be fading, presenting a potential selling or shorting opportunity.

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

RSI and Bollinger Bands Volatility Analysis

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

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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 a volatility extreme (upper or lower Bollinger Band) and a momentum extreme (RSI overbought or oversold), the probability of a reversal increases significantly.

Specific trading signals are as follows:

• Buy Signal: When the price touches or briefly breaks below the lower Bollinger Band. At the same time, the RSI shows oversold conditions (below 30). This combination indicates that the price has statistically deviated from its mean and that downward momentum has reached an extreme, presenting a potential buying opportunity.
• Sell Signal: When the price touches or briefly breaks above the upper Bollinger Band. At the same time, the RSI shows overbought conditions (above 70). This suggests that the price’s upward move may be unsustainable from both a volatility and momentum perspective, presenting a potential selling opportunity.

It is important to note that in strong trending markets, prices may “walk the band”. In such cases, this reversal strategy will fail. Therefore, before applying this combination strategy, it is best to first determine whether the market is in a ranging state by using other tools (such as long-term moving averages or the ADX indicator).

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

The true power of RSI does not come from using it in isolation, but from a deep understanding of market conditions and the synergy it creates when combined with other analytical tools. A professional trader must be able to interpret RSI behavior (such as detecting passivation) to determine whether the market is in a trending or ranging mode, and then adjust their trading strategy accordingly – seeking reversals in ranging markets and following the trend in trending markets.

More importantly, combining RSI with tools such as moving averages, MACD, and Bollinger Bands to build a multi-dimensional, mutually confirming analysis framework is key to filtering market noise and improving decision-making quality. This requires traders not only to master the practical use of these tools, but also to understand the mathematical principles and design philosophy behind them.

In your trading journey, CashbackIsland is committed to being your indispensable professional partner. Our purpose goes far beyond being a platform that offers trading rebates. We are a comprehensive resource hub, dedicated to empowering our users through in-depth, professional educational content like this, combined with the convenient calculation tools and timely market updates available on our website. We believe that by helping you master powerful analytical tools such as the RSI, you will be able to navigate the global financial markets with greater confidence, rationality, and efficiency, ultimately achieving your trading goals.

CashbackIsland continuously updates its trading education resources. Traders can visit the “CashbackIsland Learning Guide” section to gain more forex knowledge and investment skills.

Frequently Asked Questions

Q1. What Is the Best Parameter Setting for the RSI Indicator?

While the default 14-period setting is widely used and relatively balanced, there is no single “best” setting. The optimal parameters depend on your trading style and the market’s 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 may produce false signals. Professional traders often combine RSI with other indicators such as moving averages, MACD, or Bollinger Bands to cross-verify signals and build a more robust trading strategy.

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