RSI can be used to identify the general trend and signs weakness in current trend.
The RSI is considered overbought when above 70 and oversold when below 30. Other
signals generated by indicator divergences, failure swings and centreline crossovers.
Overbought / Oversold
One of the most common uses of the RSI Index is to identify extreme price movements.
Once prices enter overbought or oversold zones, traders should consider liquidating
positions or reducing current position. By watching extreme levels in the RSI will
prevent buying at the top or selling at the bottom. Only when prices confirm a trend
reversal should traders consider fading or trading against a prevailing trend. A
common mistake novice traders make is to use the RSI Index in isolation and enter
into contra trend trades.
Centreline crossover can be used to confirm a trend reversals following move out
of overbought or oversold zones. Generally readings above the centreline indicate
bullish momentum and readings below the centreline indicate bearish momentum. Looking
at the Nordic American Tanker (NAT) chart below, we see that the RSI Index was below
30 indicating oversold conditions at the end of January. This suggested that shorts
should either exit their or reduce their short positions. In February, we do see
the RSI move above the 30 level as downward momentum dries up. This is where novice
traders would typically prematurely initiate new long positions. NAT proceeded to
trade sideways for the next month most likely whipsawing weak longs in the process.
Finally, in March we see the RSI Index cross the centreline confirming the price
break above the 24.75 resistance level and the beginning of a trend reversal.
One of the more reliable techniques when employing RSI indicator is to look for
divergence between the direction of the indicator and the direction of prices. Divergences
can serve as an early warning that the current trend is about to change. Divergences
can be either positive or negative. Positive divergence occur when the RSI indicator
advances and the underlying shares decline. Negative divergences occur when the
RSI indicator declines and the underlying shares advance. In the Accuride Corporation
chart below we see an example how the divergence in the RSI indicator signalled
when the 4 month upward trend was about to reverse. The RSI divergence was the first
signal that the upward momentum was weakening even though prices formed a consolidation
pattern from throughout September.
In contrast to divergences, Failure swings are independent of price action and based
on the RSI indicator alone. A bearish failure swing forms when RSI moves above 70,
pulls back, bounces, fails to exceed 70 and then breaks its prior low. It is basically
a move to overbought levels and then a lower high below overbought levels. Bullish
failure swing forms when RSI moves below 30, bounces above 30, pulls back, holds
above 30 and then breaks its prior high. It is basically a move to oversold levels
and then a higher low above oversold levels.
ACW is nice example of using Failure swing to initiate a short position at 15.00.
RSI is a versatile momentum indicator that can be used by traders in a number of
ways. In simplest use, indicators can stop traders from buying at tops and selling
at lows. Momentum indicators can help traders’ time entries to trade in the
direction of the trend on pullback opportunities. Positive and negative divergence
can help traders see weakening trends that may not appear in price charts. The RSI
index can help novice traders take some of the mystery out of why some trends begin