Trading Blog | 5 min read
How to trade using the Relative Strength Index
The Relative Strength Index is one of the best indicators to determine whether an asset is over or undervalued and in turn determine the best time to trade (buy/ sell).
Written by Starttrading.com
Have you ever entered a trade or bought an asset hoping for the trade to go your way, but instead the trade has instantly gone the other? Don’t worry it happens to beginner traders every single day. If only there was a way to see how over or under valued a currency pair, stock or cryptocurrency is at any time… It’s your lucky day, this ultimate beginners guide to mastering technical analysis is going to break down the Relative Strength Index (RSI) and show you how to trade using it!
What Is Relative Strength Index – RSI?
The relative strength index (RSI) is a momentum indicator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a currency, stock, cryptocurrency or any other asset. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100.
Typically traders interpret an RSI value of 70 or above as an indication that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.
What does Overbought mean?
An overbought asset means that the asset is currently overvalued and that excessive buying has lifted prices. Anytime the RSI level is above 70 it means that the asset is overbought (recently having a hard run up).
This is usually due to the market becoming irrational, such as during news releases. Often leading to FOMO (Fear Of Missing Out), in which ‘late comers’ will start to enter positions to try and make a quick profit.
Typically when a currency, stock, community or cryptocurrency is overbought it is not a good opportunity for you to BUY or open a LONG position. As the market will likely correct to the downside. Try to think of this as a car driving up a very steep hill and having to take regular breaks to cool off the engine, meaning the price needs to cool off before it can continue higher.
On the other hand, anytime the RSI level is above 70, this is likely a much better opportunity to SELL or open a SHORT position. When trading, especially using the RSI its important to remember the famous Issac Newton quote “What Goes Up Must Come Down”.
What does Oversold mean?
An oversold asset means that the asset is currently undervalued and that excessive selling has dropped prices. Ironically, this is also usually due to the market becoming irrational, however, lower prices often lead to FUD (Fear, Uncertainty and Doubt).
This is usually due to rising sell pressure caused by news events, supply zones, market panics and selloffs. Typically when a currency, stock, community or cryptocurrency is oversold it is a good opportunity for you to BUY or enter a LONG position. As the market will likely correct to the upside in the near future.
When it comes to technical analysis and in particular the Relative Strength Index. No currency pair or cryptocurrency stays as strict to the RSI as Bitcoin. As shown in the example, throughout the history of Bitcoin, anytime the RSI level has been over 70 the price has seen a sharp correction back down, correlated by a drop in RSI level to below 70.
When trading Bitcoin it often drops straight into oversold territory below 30, this is when experienced traders are likely to place BUYS or LONG positions. The probability is much greater that the price will bounce from oversold levels.
Alternatively, when the price is over 70 on the RSI and considered overbought, there is a much higher probability that the price will decrease in value, as it has proven to do so time and time again.
Limitations Of The RSI
The RSI compares both bullish and bearish price momentum and displays the results as an oscillator that can be placed alongside a price chart. Like most technical indicators, its signals are most reliable when analysing the long-term trend. True reversal signals are rare and can be difficult to separate from false alarms.
Since the indicator displays momentum, as long as an asset’s price momentum remains strong (either up or down) the indicator can stay in overbought or oversold territory for long periods of time. Therefore, the RSI is most trustworthy in an oscillating market when the price is alternating between bullish and bearish periods.
This is also how institutional investors and the “smart money” invest capital, it is extremely important to trade like the smart money and have the mindset of an institutional investor to benefit like one. Following the simple RSI strategy laid out will greatly improve how you determine whether an asset is over or undervalued and allow you to get the best results out of your trades.
Remember the aim of the game is to “buy it low and sell it high” and don’t trade with your emotions or let your emotions overcome your better judgement. It is important to note that the RSI indicator can stay overbought and oversold for long periods of time.
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