Whenever a new entrant begins their trading journey, they will be flooded with information about technical indicators and acronyms. They’re often told something along the lines of “This is the secret to trading“.
NEWS FLASH: It is not.
Technical indicators are useful when properly applied but should not be used on their own to make decisions.
The most commonly used indicator is: The Relative Strength Index or RSI.
The RSI is calculated based on the average gains/losses over a certain time period – by default that is 14 days.
The formula is:
RSI = 100 – [ 100 / (1+ RS) ]
& RS = Average Gain / Average Loss
Overbought & Oversold
Typically, RSI > 70 considers an asset to be “Overbought” and an RSI < 30 considers it “Oversold“. People often here the sentence: “Sell when it’s overbought and buy when it’s oversold”.
This is a misconception and really bad advice.
Using the RSI
The Relative Strength Index is a momentum indicator. In reality, this means selling based on RSI figures above 70 often leads to one missing a major portion of a rally. Why? Because a high RSI indicates that the market is trending. The same can be applied to oversold conditions – the market is trending down and one would buy before a larger downside push.
The RSI’s use mainly comes in for checking on the momentum’s health, whether buyers/sellers are getting exhausted but it cannot be used to find tops & bottoms. That is where the concept of divergences comes in.
When a market is trending down and price action is continually creating lower lows, while the RSI is registering higher lows then that means the downside momentum is getting exhausted and seller strength is dissipating. This is called a bullish divergence.
Conversely, the opposite is also valid: higher highs in price with lower highs on the RSI indicates buyer momentum exhaustion and is called a bearish divergence.
Take a look at the chart below.
Price was creating lower lows while the RSI was generating higher lows. This was indicating that each new push to the downside became shallower and eventually that led to buyers overpowering sellers and a market reversal.
Of course, the RSI is not a main decision maker but rather a confluence indicator. With a falling wedge formation and incoming price support, a bullish divergence increases the odds of success for a price reversal.