Trading RSI overbought / oversold areas
The Wilder relative strength index (RSI) is a price momentum indicator:
- values above 70 indicate an overbought situation, from which a correction of the uptrend or the beginning of a downtrend could occur;
- values below 30 indicate an oversold price area from which a correction of the downtrend or the beginning of an uptrend could take place.
These are the trading rules using the RSI in its simplest way as overbought/oversold indicator:
Buy when the RSI indicator rises above 30 from below
Sell when the RSI indicator drops below 70 from above
The above trading rules are more likely to generate a profitable trade if the volume level at the 30/70 RSI levels breakouts is high compared to the previous trading days.
The main limitation using the RSI as a simple overbought / oversold indicator is that this trading strategy could lead to false entry signals.
This is because the cases where the price keeps going up in overbought situations or going down in oversold situations are not uncommon.
In other words, the indicator does not indicate when to enter into a long or sold position.
The chart below shows the overbought and oversold areas: you can see if the RSI is in overbought or oversold areas, but you don’t get clear signals of where to enter.
Just following the mere breakouts could lead to negative trades especially if you adopt strict stop loss points.
Why trading the basic RSI could be unprofitable
The main reason why trading RSI in its basic form can be unprofitable is because the price may continue to go up when the RSI is in overbought area and down when it is in oversold area.
Example of price trending up with the RSI is in overbought area
Not only that, but many time it could be heptic to go long when the RSI goes from below to above the 30 level, or to go short when the RSI goes from above to below the 70 level.
The following charts are even more difficult and risky to use: if you don’t have a system to decide where to enter and to exit, the trading could be quite unprofitable.
Trading Price/RSI Divergence
Trading the RSI when the price trend diverges from the indicator trend brings to better results; statistics say that the success rate of this trading strategy is above 75%.
Divergence occurs when:
in an uptrend the price makes a higher high and the RSI makes a lower high: be ready for a short trade
in a downtrend the price makes a lower low and the RSI makes a higher low: be ready for a long trade
The trading rules with bullish and bearish divergences are the following:
enter a long position in presence of a bullish divergence if the RSI breaks above the 30 level from below
enter a short position in presence of a bearish divergence if the RSI breaks below the 70 level from above
Avoid trading when the RSI is in a neutral zone between 30 and 70.
Entry points
Even trading divergences, like trading oversold-overbought situations, does not give the trader precise entry points.
The solution is to add to the RSI divergence trading other trading tools to identify the entry point.
Nevertheless, the RSI has become one of the most used indicator for successfull trading.