RSI stands for Relative Strength Index and is used by traders as a momentum indicator. It measures the magnitude of recent price changes to determine if an asset’s price is overbought or oversold.
Traditionally, an RSI reading below 30 indicates that an asset is oversold and a reading above 70 indicates that it is overbought.
The truth is that this grossly over simplifies this indicator and often causes its misuse by novice traders, often to their detriment.
The purpose of this article is to break down the misconceptions surrounding the RSI and to teach you how to use it properly in under 2 minutes.
● Use the BTSE charting platform to plot the RSI
● Overbought conditions on the RSI don’t always signal tops
● Oversold conditions on the RSI don’t always signal bottoms
● The direction of the overall trend is important when interpreting RSI
● RSI support and resistance levels can indicate bullish and bearish trends
● RSI divergence is an often overrated determinant of tops and bottoms
How to Use the RSI Indicator
Step 1: Find a chart on the BTSE platform.
Step 2: Click on the ‘Indicators’ button in the top chart toolbar.
Step 3: Select ‘Relative Strength Index” from the drop-down menu.
Step 4: See the RSI reading and oscillator plotted under the price chart.
How to Trade Using RSI
Before you trade using the RSI, you need to identify whether the market is consolidating or trending.
Basic signs of a consolidating market:
● Price oscillates sideways between support and resistance
● RSI oscillates between ‘overbought’ and ‘oversold”
● Different assets will have slightly different oversold and overbought levels
In the blow consolidation, ~RSI 40 is representing oversold conditions, and RSI 60-70 signalling overbought.
Typical RSI Buy and Sell signals in a consolidating market:
● A buy signal occurs when RSI crosses from below the oversold level to above it.
● A sell signal occurs when RSI crosses from above the overbought to below it.
Note: Price will often move aggressively when the overbought or oversold RSI levels are hit. This is why waiting for the cross is important to avoid entering trades too early.
Basic signs of a trending market:
● Price makes higher highs and higher lows in a bullish trend.
● Price makes lower highs and lower lows in a bearish trend.
● RSI will oscillate between ~50 and ‘overbought’ in a bullish trend.
● RSI will oscillate between ~50 and ‘oversold’ in a bearish trend.
In the below example, the key bullish / bearish RSI level is ~47:
Typical RSI Buy and Sell signals in a trending market:
● A buy signal occurs in a bullish trend when RSI touches the RSI support level.
● A sell/short signal occurs in a bearish trend when RSI touches the RSI resistance level.
Pro tip: Trade with the trend
● Don’t sell in a bullish trend when RSI is ‘overbought’.
● Don’t buy in a bearish trend whe RSI is ‘oversold’.
Using RSI to Signal Major Tops and Bottoms
There’s an old saying that used to circulate on the trading floor: “if you try to pick bottoms, you end up with dirty fingers”. The same goes for picking tops.
Nevertheless, accurately guessing a top or a bottom of a trend can be very lucrative.
Misconceptions about using RSI to pick tops and bottoms
● An overbought RSI is not a good indicator of a top
● An oversold RSI is not a good indicator of a bottom
● A heavily overbought RSI (above 80) can sometimes indicate the start of an explosive trend.
● RSI divergence can sometimes indicate tops and bottoms
In the below example:
● Price makes a higher high and a higher lower
● The corresponding RSI makes a lower high and a lower low.
This is called an RSI divergence.
In this example, the RSI divergence successfully picked the top of the bullish trend and the beginning of a sharp sell-off.
The reality is, there are many examples where an RSI divergence does not signal a top or bottom.
Experienced traders will often look to combine RSI divergences with other indicators, such as longer-term support and resistance levels, before making hasty trading decisions.
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