Technical Analysis isn’t just about trading the trend. It has techniques up its sleeve to identify the reversal. And the best among the lot to identify the reversal is the Relative Strength Index, aka RSI indicator. It defines the overbought and oversold zones of the market and the RSI crossover from the zones signals a profit booking (correction) rally or trend reversal. So when the trend bucks, make bucks with the RSI indicator.
Relative Strength Index – The momentum oscillator
RSI indicator is a measure of strength and momentum of the price moves. And the measure is plotted on a scale of 0-100.
It does not elasticate as the price extends. So, it is an oscillator.
The general convention with the RSI indicator is, “what goes up will come down”.
Overbought and Oversold with RSI Indicator
When the RSI indicator prints a reading of above 70, it hints the asset is in an overbought condition and is due for a correction.
Likewise, a reading of below 30 signifies that the asset is in an oversold condition. It instigates a demand on the asset.
The values 70 and 30 are only indicative. Traders use different combinations, say 20–80. It depends on their style and aggressiveness.
The above chart explains the overbought and oversold zone. The red zone above 70 marks the overbought zone which conveys not to go long. Likewise, the green area below 30 signals the oversold zone or not to short. When the bullish (or bearish) momentum withers, the indicator crossovers to the below 70 (or above 30) region which marks the beginning of a corrective rally.
How to trade the trend reversal with RSI crossover?
When the market is in an overbought or oversold condition, profit booking is customary.
It results in a pullback or throwback.
At times it extrapolates to a trend reversal too.
Hence, RSI crossover has a greater significance as it identifies the reversal at the outset.
Case #1- Bullish RSI Crossover
It ferments when the indicator crosses the value of 30 from below.
Since the indicator moves out of the oversold zone, it indicates the buying demand has crept into the counter.
And traders leverage it by going long.
In the above image, GBP/AUD was in a steep downside rally.
A reading of below 30 marks the potential reversal zone. It is a caution zone for traders, where your friend(trend) can become a foe, anytime soon.
But it does not mark a trend reversal yet.
Only when it cuts the value of 30, it marks the commencement of a new trend. As you can see, when that happened, a robust upmove of 300-400 pips followed.
Case #2 – Bearish RSI Crossover
The bearish crossover precipitates when the indicator cuts the value of 70 from above.
It results in either a pullback or a reversal.
During the 2017 Bitcoin bubble, the RSI indicator played a significant role.
It indicated the mild corrections initially, which are mere pullbacks from a retrospective point of view. In real-time, it would have given ample profits or a bargain buying opportunity.
However, it is in late 2017, the RSI indicator proved its mettle by signaling a bubble burst in Bitcoin way ahead. And a monstrously sell rally followed.
- The ensuing rally of RSI crossover is proportionate to the preceding trend rally. The more the prior rally the further the corrective rally.
- RSI crossover identifies the overbought and oversold condition in a trending market. To identify the overbought and oversold condition in a sideways market, use Bollinger Bands.
Chart patterns in RSI
It is a unique aspect of the RSI indicator. Patterns do not form in most indicators.
However, they do form in the RSI indicator.
The most common patterns featuring in the RSI are double top, double bottom and head & shoulder.
The chart patterns share the same significance as they do in price action. It’s even when they form in RSI as it renders an advance signal.
The above candlestick chart can be meaningless to many. However, if you add RSI Indicator, it renders magic. An inverse head and shoulder pattern formed in the indicator which signaled the momentum reversal. Likewise, the spike is brought to an end with another head and shoulder pattern in the index.
Note: The patterns may or may not form at the overbought and oversold zone.
Ideal settings of RSI Indicator
The general setting used for the Relative Strength Index is 14 – period.
However, aggressive traders can use the value of 9-period as well, to identify reversals in shorter time frames. The method produces a higher number of signals, but the accuracy takes a hit.
In contrast, a conservative long-term trader uses 21-period to smoothen the waves.
The psychology behind the RSI Indicator
J. Welles Wilder created the RSI Indicator to solve two critical problems.
#One, to identify the precise momentum of the market amidst the noise and fluctuations in the market. The charts become a mess when prices are riveted at a spot. The price tick but not the action.
And it takes immense strength to move the RSI indicator even a whisker. So, it smoothens the price action and negates the fluctuation to a greater extent.
Furthermore, it defines the overbought and oversold conditions of the market. The RSI crossover from the overbought and oversold zones gives an idea of profit booking during overextended rallies to the short-term traders.
#Two, is to provide an avenue to compare the strength of two rallies. For instance, if the down move is not as vigorous as the up rally, then it interprets a corrective wave.
Further, the custom is that the price and RSI indicator are to move in tandem. When one creates a new high (or low), the other is set to follow.
When it doesn’t, it creates a divergence. Read more about in divergence in indicators and price action here.
Where RS=Average of H/Average of L
H – up closes in the specific time frame.
L- down closes in the specific time frame.
RSI Indicator is a momentum oscillator ranging between 0 to 100.
As the name indicates, it measures the strength and momentum in the market.
RSI Indicator defines the overbought and oversold condition of the market.
- Overbought – Above 70.
- Oversold – Below 30.
Bullish RSI crossover – cuts 30 from below.
Bearish RSI crossover – cuts 70 from above. The crossovers indicate either a corrective rally or trend reversal.
Traditional parameter used is 14 period.
The indicator also forms patterns like the double top, the double bottom and the head and shoulder.