4.34 Using Relative Strength Index (RSI) for Trading
Relative Strength Index, or simply RSI, is another momentum oscillator that helps us to visually see markets where they are – in overbought or oversold zone. If the price-action is indicating an overbought situation, chances are that selling may start soon and prices may start falling. Opposite is true that an oversold situation may cause traders to line up for long position to make the prices jump up.
The RSI was created by J Welles Wilder and is one of the popular indicators used to measure the speed and extent of price changes. It is normally calculated for a 14-day period and varies between the extreme values of 0 and 100. As usual we give the calculations the go-by!
When this indicator is red-lining at 70 and above, it is considered to be in an overbought zone – and it might be a good idea to be ready to sell. When the RSI is down in the dumps below 30, the market is oversold, and you look to enter as a buyer. Let’s look at the chart below.
See how in the zone marked as “oversold’ the price started to bottom out and finally took off to the upside. The first ‘overbought’ zone marked an area from which the price corrected sharply. Note that sometimes strong up trends keep the RSI in the overbought zone for quite some time. Look at the second overbought zone – the price maintained its strong trend upwards. In such a case one should look for confirmation from other oscillators, trends and support or resistance levels before simply selling the overbought readings.
The RSI can also be used to identify the current prevailing trend. The 50 level line can be used as a dividing line between bullish and bearish market territories. See the chart below. A crossover by the RSI from one zone to the mark of 50 can signal a change of trend.
How to Use RSI?
Overbought and over sold zones
As explained above, when the price-action moves above 70 i.e. into the overbought zone, sooner or later prices will tend to fall. This is the time you may sit tight to wait and watch to enter a short position. In case you do it right, you can rest assured of a handsome gain.
Similarly when the RSI dips below the 30 level, which is oversold zone, be prepared to go for a long position.
Do have a look on the following charts which explains both these situations visually:
RSI in Oversold Zone
RSI in Overbought Zone
Using RSI for Entry with Trends
When RSI moves above the 50 mark you may go for a long position as it is an indication that an uptrend is emerging. If RSI was above 50 and drops below this level, it indicates a bearish trend and you may go for a short position.
Caution while trading with RSI
During strong trend RSI would tend to remain in oversold or overbought zones for extended periods of time. Any hurriedly taken position may cause big losses at such time. Have a look on the following chart:
Before you place your order based on overbought or oversold zones, always look for breakout or reversal signs by keeping an eye on the following:
- Bullish divergence in oversold zone for buying.
- Bearish divergence in overbought zone for selling.
- Breakouts from any existing support or resistance trend-lines.
- Breakouts from any support or resistance levels.
One of the examples from the above is shown in the following chart which is self explanatory:
The above chart is an example of a very strong uptrend. See how the Relative Strength Index remained in the overbought situation for a very long time. Any short-position soon after the RSI entered into that zone would have caused some heavy losses. That could have been prevented if you would have noticed the support trend-line in place. Any trader who would have gone for a short with the breakout of that support line would have ended up with some great profits.
- Trading with RSI (Relative Strength Index)