The relative strength index (RSI) is in fact a momentum indicator that can be used to measure whether the market is currently overbought or oversold. Being able to identify the duration where the market is overbought or oversold can prevents you from entering a losing trade.
Here is how to read the Relative Strength Index (RSI)
Overall the RSI has a magnitude of 0 to 100. When it falls below the magnitude of 30, it usually indicates a situation of oversold and when it went above the magnitude of 70, it is usually indicating that the market is overbought.
However being overbought or oversold does not mean that the price will not move further up or down the market needs some time to correct itself. Similarly it also does not mean that you must enter a trade when the market is in either one of the extreme levels.
How to Use the Relative Strength Index (RSI):
1) As an Entry Indicator:
Depending on the types of market you are trading, there is a slight difference in the way you can use the RSI.
In a ranging market which means that the price is moving up and down within a range. You can use the oversold and overbought feature of this indicator to help you enter your trade.
When you see the price approaching a resistance level and the RSI rising above the magnitude of 70 which means that the market is currently overbought, you can enter a SHORT trade to profit from the range.
When the price is approaching a support level and the RSI falls below the magnitude of 30, you should then enter a LONG trade to profit from the range.
b) Trend Trading
In a trending market, the way you use this indicator to help you in entering a trade will be a bit different from the above. When you are in a trending market, you should be looking to BUY a Dip and SELL a Rally and this is where the RSI can be of use to you.
If the market is in an uptrend, you should wait for the price to retrace before you enter a trade. You can enter a LONG trade when you see the RSI dropping below the 50 marks and then curve up above it.
If the market is in a downtrend, you can enter a SHORT trade if you see the RSI rising above the 50 mark and then curve down moving below it.
2) As a Trend Indicator:
Besides using RSI as an entry indicator, it can also be used as a tool for confirming a trend. If you are in an uptrend, you can confirm it by making sure that the RSI is above the 50 mark. If you are in a downtrend, you can confirm it by checking if the RSI is below the 50 mark.
The RSI is a good tool to avoid fake outs in trend and you should always make use of this ability to confirm the trend before you enter a trade.
3) As a Divergence Indicator:
You must have heard of MACD divergence but you may not have heard of RSI divergence. But for those new traders who are reading my blog post, I will go through what divergence is all about.
A divergence occurs when the market is moving in the opposite direction as the indicators.
You will get a positive divergence which is usually formed when the market makes lower low while the indicator makes higher low. The divergence is in fact a leading indicator as it gives you a pre-warning that the market is going to reverse.
You will see a negative divergence when you see the market making higher high while the indicator makes lower high and this is usually an indicator that the market is going to move from up to down.
The above are 3 ways you can make use of the Relative Strength Index in your trading. Make sure you include this indicator into your trading toolkit as it is something that can give you an edge if you do it right.