Being a technical trader requires relying on a variety of market patterns and indicators to land informed trade decisions. While advanced software makes many of these tools readily available to traders, it is essential to know exactly what each indicator represents to effectively trade using them. One of these commonly used technical indicators in technical analysis is the RSI or Relative Strength Index.
The RSI, or Relative Strength Index, the indicator is a momentum oscillator that gives technical traders insights into the strength of a financial instrument’s price trend. Readings on this indicator fluctuate on a scale between 0 and 100, signaling traders as to when a financial instrument is in an overbought or oversold condition.
In technical analysis, the Relative Strength Index (RSI) is beyond doubt one of the most commonly used technical indicators. It is similar to other momentum indicators, such as the MACD or the Williams %R. Still, it is often the oscillator of choice for most traders when assessing momentum, as its simplistic layout and its 0 to 100 scale is very intuitive to work with. However, just as with other tools in technical analysis, using the Relative Strength Index (RSI) alone by itself has some limitations. Therefore, it should be used as one part of a comprehensive trading strategy, and you should not depend solely on this indicator to identify potential trade opportunities.
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How to Read Relative Strength Index (RSI) Indicator?
The Relative Strength Index (RSI) is a momentum oscillator, meaning that depending on the strength of a financial instrument’s price trend, indicator readings will oscillate between two extreme points. In the case of RSI, these two extreme points are 0 and 100. An indicator reading of 0 represents an extremely oversold condition, whereas, a reading of 100 represents an extremely overbought condition.
RSI Indicator is great for understanding the general trend of a stock or other asset’s price and for assessing where the true strength of the asset lies in relation to its price trend. The ultimate goal of an RSI indicator is to help you decide whether you are getting a reasonable price on specific assets or not.
To accurately read and interpret the Relative Strength Index (RSI) Indicator, it is essential to understand what these values between 0 and 100 represent, and the underlying calculations used to arrive at these figures. Therefore, before moving further into the article, let us first discuss the following topics with regards to accurately reading an RSI Indicator –
- Construction of Relative Strength Index (RSI) Indicator
- Relative Strength Index (RSI) Indicator Calculations
- Interpreting Relative Strength Index (RSI) Signals
Now, without further ado, let us dive deep into these three above-stated topics.
Construction of Relative Strength Index (RSI) Indicator
The RSI is a valuable tool in technical analysis to check whether a financial asset’s price trend is gaining or running out of momentum. This understanding can considerably help technical traders in identifying potential entry and exit points for their trades.
To indicate these readings, the Relative Strength Index (RSI) uses a layout that is structurally simple and easy to interpret. In essence, it is composed of the following two components –
- Indicator Scale: As mentioned above, the readings on the RSI Indicator can fluctuate anywhere between a scale of 0 and 100. These values are marked along the Y-axis of the indicator.
- Signal Line: This is the line that fluctuates along the indicator scale, varying based on the strength of the security’s price trend. In addition to fluctuating along the Y-axis, this line continuously moves along the X-axis, thus providing information on the momentum change trends as the price of the security being analyzed changes.
Relative Strength Index (RSI) Indicator Calculations
The Relative Strength Index (RSI) is a bit complicated to compute, as there are multiple steps involved in the process. Additionally, over the last several years, different trading experts have added their own flavor to the RSI calculation methods. Hence, based on who you are talking to, the steps involved in calculating this indicator may vary. Fortunately, there is plenty of software and trading platforms available to calculate the RSI in the background for you.
However, it is worth taking a look at the formula devised by J. Welles Wilder, Jr., in his seminal book New Concepts in Technical Trading Concepts to get an idea of how the RSI is formed. More than anything else, having an understanding of these calculations will help you interpret and implement the trading signals from this indicator.
To calculate the momentum readings, the Relative Strength Index (RSI) uses the speed and the direction of an asset’s price trend. In essence, there are four steps involved in calculating the RSI Indicator. These are –
- Step-1: Determining Lookback Period
- Step-2: Calculating Average Gain and Average Loss over Lookback Period
- Step-3: Calculating Relative Strength using Average Gain and Average Loss calculated in Step-2
- Step-4: Smoothing out Relative Strength calculated in Step-3 to get Final Relative Strength Index (RSI) reading
Described below are each of these four steps with all the necessary details that you need to know.
Step-1: Determining Lookback period
As with most other tools in technical analysis, the Relative Strength Index (RSI) is calculated based on the historical price data of a security. In essence, the indicator uses past data over a particular number of manually selected historical periods or trading sessions to help predict future price trends for an asset. This manually selected number of historical periods over which the RSI values are calculated is referred to as the Lookback Period.
A typical Lookback Period for RSI calculations collects data from 14 trading sessions, such as 14 days on a daily RSI or 14 weeks for a weekly RSI. For day trading, the 14-day Lookback is the most commonly used setting in RSI calculations.
Therefore, the first step in calculating the RSI reading is to select a Lookback period that best meets the needs of the market conditions that you are trading in and your trading psychology.
The lower the Lookback Period, the more sensitive will be the readings of the indicator to the recent price changes. In most trading scenarios, the default setting of 14 trading sessions as a Lookback Period, will deliver you trading signals with a decent reliability to incorporate into your trading strategy. However, when trading in a highly volatile market condition, you may benefit from reducing the Lookback Period slightly for short-term trading.
Step-2: Calculating Average Gain and Average Loss over Lookback Period
Once you have determined the Lookback Period, the next step involved in calculating the Relative Strength Index (RSI) is calculating the Average Gain and the Average Loss over this period.
In this illustration, assuming that the look-back period that you selected in step one is 14 days, below is how you would calculate the Average Gain and the Average Loss values in the second step of the RSI calculations –
- Average Gain – To calculate Average Gain you will take the sum of all of the daily gains (expressed as a percent) made by the asset during the last 14 days, and divide that sum by 14.
- Average Loss – To calculate the Average Loss value for RSI calculation, you will take the sum of all of the daily losses (expressed as a percent) suffered by the asset during the last 14 days, and divide that sum by 14. The RSI will always use a positive value for the Average Loss, even though the calculation will be negative when all of the losses are added up.
Step-3: Calculating Relative Strength using Average Gain and Average Loss calculated in Step-2
The next step in calculating the RSI, and perhaps the most important step, involves determining the Relative Strength of an asset over a given period.
Using the Average Gain and the Average Loss mentioned in the previous section, the Relative Strength of the asset can be computed using the following formula:
RS = 100 – [100 / (1 + (Average Gain/Average Loss))]
This will yield a value between 0 and 100 (remember, always use a positive value for Average Losses) and give you a “rough” Relative Strength of an asset’s price momentum.
Step-4: Smoothing out Relative Strength calculated in Step-3 to get Final Relative Strength Index (RSI) reading
Even though what you have calculated in Step-3 is roughly the strength of the price trend’s momentum, it is not the Final RSI reading. This is because the statistical experts like their information to be smoothed out to normalize volatility and balance historical momentum with more recent movement.
Therefore, in calculating the Relative Strength Index (RSI), Wilder used another equation to help smooth out his initial result and come up with the Final RSI reading:
RSI = 100 – [100 / (1 + ((Previous Gain*13 + Current Gain)/(Previous Loss*13 + Current Loss))]
This will also yield a result between 0 and 100 (likely similar to the result computed in Step-3 for less volatile assets) and is considered the final RSI oscillator.
Interpreting Relative Strength Index (RSI) Signals
When reading an RSI (Relative Strength Index) Indicator, it is essential to understand what the range of values between 0 and 100 represent.
- Any reading above 70 represents a potential overbought situation. While this does not necessarily mean a reversal is imminent, it can help cue in traders that current buying momentum is inflating the price to a level that cannot be held for long. As such, readings over 70 may prompt traders to strongly consider selling or short-selling the asset.
- On the other hand, any reading below 30 represents a potential oversold situation. Although this does not mean price is sure to go up soon, it does reveal that there is possibly more value in an asset than the current selling momentum would indicate. Therefore, readings below 30 may prompt traders to consider buying the asset more strongly.
- Readings between 30 and 70 indicate that there is no real trend in an asset’s momentum and that it is trading at somewhat “fair” levels; at least in comparison to what the trading activities over the past 14 days (or trading sessions) would suggest.
How Reliable is Relative Strength Index (RSI) Indicator in Trading?
Even though the Relative Strength Index (RSI) is counted among the most commonly used technical indicators, just like any other tool in technical analysis, its signals are not overly reliable when used in isolation.
- First, novice traders often assume that the overbought and the oversold conditions, when measured by momentum oscillators, are a sure sign that a reversal is imminent. While this may be true for more mature and stable assets, it is unlikely to be the case for explosive growth instruments or assets in sharp decline. Consequently, when not careful and relying solely on the RSI Indicator to make trading decisions, traders expose themselves to the risk of losing a substantial sum due to these “false” trading signals.
- Additionally, there is also evidence that the standard overbought range of 70 or higher and the standard oversold range of 30 or lower do not necessarily apply to assets amid strong trends. Some experts feel that assets in a strong uptrend are overbought when RSI is over 50, and instruments in a strong downtrend are oversold when RSI is below 50.
Therefore, to enhance the reliability of RSI, it is essential to combine it with other complementary tools, charts patterns, and indicators that are commonly used in technical analysis to enter into informed trades. By merely confirming the trade signals generated by the Relative Strength Index (RSI) using other complementary tools, you can filter through a sizable number of “false signals” generated by this indicator.
Improving Reliability of Relative Strength Index (RSI) Indicator in Trading
As mentioned previously, the Relative Strength Index (RSI) by itself is not a great indicator of an imminent reversal. This is because its many “false signals” amid strong trends can cause traders to miss out on profits or, even worse, result in losses.
However, by combining Relative Strength Index (RSI) with the concept of Divergence (bullish or bearish), you can improve the accuracy of RSI signals and more confidently identify when an asset is about to experience a change in price trend.
A Bullish Divergence would occur during a strong downtrend in an asset’s price. When, in a downtrend, the price of the security being analyzed continues to make lower lows, but the subsequent readings on the RSI indicator are higher than the readings before, the security is said to have a Bullish Divergence. In essence, the presence of Bullish Divergence on the price chart indicates a decline in the bearish momentum of the security, and thus signals a potential reversal in price trend.
On the flip side, a Bearish Divergence would occur during a strong uptrend in the price of an asset. When, in an uptrend, an asset’s price continues to make higher highs, but the subsequent readings on the RSI do not follow the suite and are lower than the previous readings, the asset is said to have a Bearish Divergence. Contrary to the presence of a Bullish Divergence, the Bearish Divergence, as the name suggests, is a bearish sign that indicates the possibility of a downward reversal in a price trend.
Hence, on top of simple Overbought and Oversold readings generated by the Relative Strength Index (RSI) Indicator, the presence of divergence on the price chart provides you with a buffer of signal confirmation. Therefore, incorporating the concept of Divergence into your trading strategy can considerably improve the accuracy of your trading decisions made using RSI.
In addition to using bullish and bearish divergences to confirm or deny RSI readings, you should also consider pairing RSI with other complementary concepts and tools in technical analysis to further improve this indicator’s reliability in trading. Some of these complementary tools measure momentum in a manner similar to RSI, while the others are more fundamental patterns that give a visual representation of price history.
Listed below are the most commonly used complementary tools that are often combined with the Relative Strength Index (RSI) Indicator to improve its reliability –
- Moving Average Convergence Divergence (MACD)
- Average Directional Index (ADX)
- Support and Resistance Levels
- Candlestick Patterns
Now, in the following sections, let us discuss how each of these four indicators can be used in combination with RSI to improve the accuracy of its trading signals.
Moving Average Convergence Divergence (MACD)
The Moving Average Convergence Divergence, also known as MACD, is another popular momentum indicator that is widely used in most technical trading circles. It uses exponential moving averages to determine the strength of the price momentum of an asset.
Similar to the Relative Strength Index (RSI) Indicator, MACD produces overbought and oversold signals to determine the possibility of an upcoming reversal, but the overall approach and the underlying calculation that goes into producing these signals are very different in the case of the MACD Indicator.
Therefore, since both these indicators, RSI and MACD, measure the strength of a trend, but using different approaches, one can use the trading signals from MACD to validate the accuracy of the signals produced by RSI and vice-versa. Hence, if the information revealed between RSI and MACD is harmonious, the trader’s buy, sell, or hold opinion can be strengthened, and the accuracy of trading decisions made using RSI can be enhanced.
Average Directional Index (ADX)
The Average Directional Index (ADX) is another moving average indicator that is used to measure the strength of a price trend. Above all else, you can leverage the ADX as a confirmation indicator to validate the trading signals generated by RSI (Relative Strength Index).
Below is how you would integrate readings from ADX (Average Directional Index) into your RSI trading strategy –
- When the trading signals from both ADX and RSI indicate a reversal, the signals generated from RSI are considered more reliable. Hence, it would be relatively safer to enter trades when these two indicators are in sync.
- Contrarily, when the trading signals generated by ADX and RSI are not in complete harmony, the signals produced by RSI are deemed less reliable. In such scenarios, you should avoid making a trading decision based on RSI output.
Finally, to conclude, the trader sentiment to enter a buy or a sell trade, and the accuracy of such trades, can be strengthened when the ADX movement is consistent with RSI momentum.
Support and Resistance
Support and Resistance is perhaps one of the most popular and foundational concepts in technical analysis. At its core, these levels indicate the points at which the price trend of a security is most likely to reverse.
- The Support represents the region on the price chart at which there is considerable buying pressure for a financial instrument. Consequently, whenever the price of the instrument falls to these levels, in an attempt to buy the security at a reasonable price, more and more investors rush into the market. This surge in demand for security often acts as a catalyst, triggering a bullish reversal in price trends.
- Contrarily, the Resistance indicates the region on the price chart with sizable selling pressure for a security. As a result, when the price of the security rises to a resistance level, the holders of the security begin to exit their positions to book profit. Parallelly, in anticipation of profit from a decline in security’s price, a series of short-sellers start to enter the market at these levels. Consequently, the upward price trend of the security loses its momentum, and very often a bearish reversal gets triggered at these Resistance levels.
Therefore, in summary, Support and Resistance are the levels on a security’s price chart of a security at which the probability of a reversal is the highest. At its core, this is driven by a considerable buying or selling pressure for the security at these levels.
Now, as you would have noticed based on the above description, when added to your Relative Strength Index (RSI) trading strategy, these Support and Resistance levels can considerably improve the accuracy of your trades. Stated below are a few guidelines on how you would integrate these levels into your RSI trading strategy –
- When your RSI (Relative Strength Index) Indicator reflects an oversold condition and the price hovers around an established Support level, the probability of a bullish reversal is extremely high. Therefore, in situations such as these, your success probability with a bullish trade will be reasonably high.
- Contrarily, when the security’s price is around an established Resistance level and your RSI Indicator signals an overbought condition, the odds of a bearish reversal are very high. As a result, the odds of your success with a bearish trade in such situations get a considerable boost.
Finally, to conclude, using Support and Resistance levels in conjunction with the Relative Strength Index (RSI) Indicator can sizably boost the accuracy of your trading decisions.
Candlestick Patterns
Candlestick charts have long been the preferred choice of trading charts for active investors and traders. Every candlestick on these price charts gives a visual representation of an instrument’s price performance, as well as specific information as to open, close, high, and low prices. Additionally, each candlestick reveals valuable information on the market psyche that traders can leverage in making predictions regarding the future performance of the security.
Based on the market psyche that they represent, the candlestick patterns are broadly classified into two main categories. These are –
- Reversal Candlestick Patterns
- Continuation Candlestick Patterns
You can leverage both these pattern types to improve the accuracy of your trading decisions made using the Relative Strength Index (RSI) Indicator. Described below are few pointers on improving the accuracy of your trades by using each candlestick pattern type in conjunction with trading signals generated by Relative Strength Index (RSI) Indicator –
- Reversal Candlestick Patterns: These are the candlestick patterns that indicate an upcoming reversal in the price trend. Therefore, when your RSI Indicator signals an overbought or oversold condition, the presence of a Reversal Candlestick Pattern on the price chart can be treated as a confirmation sign for that trading signal. Hence, the accuracy of your reversal trade decisions made using the Relative Strength Index (RSI) Indicator can get a sizable boost by including the Reversal Candlestick Patterns into your trading strategy.
- Continuation Candlestick Patterns: Contrary to the Reversal Candlestick Patterns, the Continuation Candlestick Patterns signal a continuation of the prevalent price trend. Therefore, if you see a Continuation Candlestick Pattern on the price chart when your RSI Indicator gives an overbought or oversold reading, it should be treated as a sign of caution. Since, in these situations, the trading signals generated by the RSI and the Candlestick Patterns are not harmonious, you are better off avoiding such trades.
Finally, to conclude, the candlestick patterns can be used to solidify or to weaken the trading signals generated by the Relative Strength Index (RSI) Indicator. Hence, they can serve as great confirmation tools in your RSI trading strategy, and can thereby improve the accuracy of your trading decisions made using the RSI Indicator.
How to Trade Using Relative Strength Index (RSI) Indicator?
Now that we have covered various methods to improve the reliability of trading signals generated by the Relative Strength Index (RSI) Indicator, along with its basic structure, calculations, and signal interpretations, it is time to put this knowledge to work and learn how you can effectively trade using this indicator.
Generally speaking, a sound trading strategy will almost always leverage signals from multiple tools and analysis methods. When trading such a strategy, it is always a good idea to have a prevailing notion on using each specific tool or indicator as one piece of the puzzle that, when combined with other pieces, can help you be more confident in your final trading decision.
That being said, there are several trading strategies in which the Relative Strength Index (RSI) plays a pivotal role. The most popular of these trading strategies are listed as follows –
- Breakout Trading Strategy
- Reversal Trading Strategy
- Momentum Trading Strategy
Now, in the following sections, let us discuss how you can leverage RSI in each of these three strategies to identify trade entries, set stop-loss levels, and determine take-profit levels.
Trading Strategy 1: Breakout Trading Strategy
The Breakout Trading Strategy is one of the most popular methods of trading in technical analysis. In this strategy, you enter into a trading position when the price of a security either breaks out of an established Support or a Resistance level. Typically, the break of an important Support or Resistance level is coupled with an explosive price movement in the direction of the breakout. It is this explosive move that the traders intend to capitalize on when trading this strategy.
In essence, with breakout trades, you target to capitalize on the fear (bearish breakout) and the euphoria (bullish breakout) in the market and ride this overriding market psychology to capture huge profits. Breakouts do not perform “normally” and are often not supported by underlying fundamentals. Therefore, along with the asset establishing new Support and Resistance levels, eventually, the reality will set in and the explosive price wave that you are riding will lose its momentum. That being said, in the short-term, the Breakout Trading Strategy is perhaps one of the best ways to capture enormous gains in a relatively small window of time.
When looking for breakout trades, the Relative Strength Index (RSI) can play a pivotal role in identifying and confirming your trade entries and exits. Let us discuss, in the following sections, how you would determine your trade entries, stop-losses, and take-profit levels under the Breakout Trading Strategy using the Relative Strength Index (RSI).
Determining Trade Entry
When an asset is ready for a breakout, the RSI (Relative Strength Index) will almost always indicate a strong overbought or oversold condition. However, rather than predicting a reversal, these strong overbought or oversold signals could signal an imminent breakout.
Based on this above-stated guideline, here is how you would confirm entry for a breakout trade using the Relative Strength Index (RSI) Indicator –
- When the price is near an established Resistance level and there have been multiple successive near 100 RSI readings, it is an indication that a Bullish Breakout might be near, and hence you should consider taking a long trade.
- Contrarily, when the price is near an established Support level, and the RSI has indicated multiple near 0 successive readings, it signals a potential Bearish Breakout. In situations such as these, you should consider selling or short-selling the security.
Finally, as you would have noted with the above-stated guidelines, the prerequisite to entering potential breakout trades using the Relative Strength Index (RSI) Indicator is to identify the Support and Resistance levels from where a breakout is likely. To do so, you can either leverage various traditional Support and Resistance level types (such as – the Horizontal Support and Resistance Levels, the Pivot Points, the Fibonacci Retracement and Extension levels, etc.) or rely on various Chart Patterns (such as – the Head and Shoulders Pattern, the Wedges, the Flag Pattern, etc.).
Determining Stop Loss Target
With the Breakout Trading Strategy, it is fairly easy to set a stop-loss when trading breakout, as any retreat back to the previous Support or Resistance level would indicate that a breakout is not truly taking place. Therefore, below is how you would place the stop-loss for your trades under this strategy –
- In the case of a long trade, your stop loss will be placed a few points below the Resistance level, on the break of which you entered into the trade.
- On the flip side, in the case of short or short-sell trades, you will place the stop loss for your trades a few points above the Support level, on the break of which that trade was entered into.
Additionally, once the price has moved enough in the direction of your trade, you can switch to a trailing stop loss. This will allow you to ride the explosive wave of price movement post-breakout while keeping your risk of losing out on any unrealized gains low.
Determining Take Profit Target
The idea behind trading breakouts is to capture explosive gains. Therefore, as a general guideline, with the Breakout Trading Strategy, the Take Profit level that you target should not be modest. Most experienced traders expect at least a 10% return when employing this strategy.
With that said, below is how you can leverage the Relative Strength Index (RSI) Indicator in determining the trade exits under this strategy –
- In the case of a long trade, when the bullish momentum on the RSI dies down and there is evidence of Divergence on the price chart, you should consider closing your position for profit.
- Similarly, with a short or short-sell trade, when the bearish momentum on the RSI tapers off and you see Divergence on the price chart, it is an indication that the breakout may be running out of steam. It can therefore be treated as a signal for you to book your unrealized profits by closing your short position.
Finally, when trading breakouts, in addition to relying on the momentum readings from the Relative Strength Index (RSI) Indicator, you could greatly benefit from using certain external tools, such as – the Fibonacci Retracement and Extension levels, in determining Take-Profit targets.
Trading Strategy 2: Reversal Trading Strategy
The Reversal Trading Strategy is another popular technique that is commonly used by technical traders. Generally speaking, this strategy works really well when you are trading a mature asset and its recent price action is not supported by underlying fundamentals, causing investors to feel that a pullback is imminent.
From the technical analysis standpoint, as you would have noted based on everything covered in this article thus far, the Relative Strength Index (RSI) is one of the most widely used technical indicators to execute this strategy. This is because, in this strategy, you primarily look for whether an asset is overbought or oversold to determine the likelihood of an upcoming reversal.
That being said, as also mentioned earlier in the article, the Relative Strength Index (RSI) by itself is not the most accurate indicator for identifying reversals. However, in combination with other complementary tools, such as the Candlestick Patterns, Chart Patterns, Support and Resistance, etc., the reversal signals generated by it are very reliable. For example, if a chart pattern on the price chart shows that a correction in a bull market is likely, and this is followed by an overbought reading on the RSI, the success probability of a sell or short-sell trade at such a point turns really high.
However, when trading reversals with the Relative Strength Index (RSI) Indicator, nothing is quite as powerful as the bullish and the bearish divergences. These lower highs and higher lows can truly help confirm that overbought or oversold conditions are likely to lead to a reversal, making them ideal indicators to help traders beat a market correction.
Now, let us briefly discuss how you would enter and exit trades under the Reversal Trading Strategy using the RSI Indicator.
Determining Trade Entry
As discussed above, the most reliable way to trade reversals using the Relative Strength Index (RSI) Indicator is to trade using divergence. Hence, below is how you would enter a trade under this strategy –
- In an uptrend, when an overbought reading on RSI is followed by a lower overbought reading, but the corresponding reading on the price chart is higher than the previous high, you should look for confirmation signals and short-sell the asset.
- Contrarily, in a downtrend, when the price makes a lower low but the corresponding oversold reading of the RSI is higher than the previous low, a bullish reversal is likely. Hence, in situations such as these, you should wait for a confirmation sign and enter a buy trade.
For confirmation signals for trade entry, there are several options that you can explore. One popular tool for this purpose is the Candlestick Patterns. Additionally, by integrating Chart Pattern Trading into this strategy, you can significantly boost the accuracy of your trades with this method.
Determining Stop Loss Target
With this strategy, you would put your stop loss at a point where it is confirmed that the reversal signal on which you based your trade was false. To do so, you would take an approach that is quite opposite to the one that we took in the Breakout Trading Strategy –
- In the case of a bearish or short-sell trade, your stop loss will be a few points above the most recent high. If the price moves above this high, your reversal hypothesis gets invalidated and it is time for you to minimize your losses by exiting the trade.
- On the flip side, when taking a bullish or a buy trade, you would put your stop loss a few points below the most recent low. This is because if the price continues to fall below this point and forms yet another low, your hypothesis for reversal gets invalidated.
In combination with these above recommendations, you can also use RSI to confirm the invalidation of your reversal hypothesis. Listed below are few guidelines to do that same –
- With bearish trades, after initial divergence, if the overbought reading on the RSI scale jumps back to a level that is higher than before, it means that divergence no longer exists on the price chart. This confirms that your original hypothesis of a reversal has been invalidated.
- Similarly, in the case of bullish trades, if you get a lower oversold reading than before after the initial sign of divergence, your hypothesis for a reversal trade gets invalidated. Hence, you should consider closing your position to minimize losses at this point.
Determining Take Profit Target
While not quite as bold as those trading breakouts, those taking reversal trades will also want to capture healthy returns. Even though the exact value depends mostly on an individual’s trade volume and risk tolerance, a gain of 5-10% is a realistic range for reversal traders. The profit targets for reversal trades are generally lower than breakout trades because there is always the threat that a reversal is just a momentary correction in a strong previous trend.
With that said, listed below are a few tips that you can leverage in determining your take profit targets under this strategy –
- Once your trade is well into the profit territory, you should start looking for divergence in the direction opposite to your trade entry. Therefore, if your trade entry was based on bullish divergence, you should look for bearish divergence on the price chart. Once that divergence appears, you should consider closing your position for profit.
- External tools, such as the Fibonacci Retracement and Extension Levels, are great at determining the ideal exit targets for your trades. You should integrate such tools into your Reversal Trading Strategy for better exits.
- When implementing this strategy on chart patterns, every chart pattern gives some high-level guidelines in terms of what your take profit target should be. Hence, you should leverage such insights in formulating your trade exit strategy as well.
Trading Strategy 3: Momentum Trading Strategy
The Momentum Trading Strategy is perhaps the most straightforward and easy to understand trading strategy. The essence of this strategy is the “buy low, sell high” thought process, which is foundational to traders and investors at all experience levels. That being said, for the contrarian short-sellers out there, this strategy would mean “sell high, buy low”.
With the Relative Strength Index (RSI) Indicator is a momentum oscillator, it may seem intuitive to believe that indicator is an ideal choice for those trading the momentum strategy. The overbought and the oversold signals that the RSI generates are often considered as signs that an asset’s price momentum is a bit artificial and is due for at least a correction. However, as discussed earlier in the article, that is not necessarily the case.
Nonetheless, the RSI can be a very valuable tool for momentum traders if some specific nuances and techniques are used. This is particularly true when trading a mature security in a range-bound market condition.
Now, in the following sections, let us discuss how you can determine favorable trade entries and exits using the Relative Strength Index (RSI) Indicator to execute the Momentum Trading Strategy.
Determining Trade Entry
The RSI can be an excellent tool for identifying trade entry for a momentum strategy in a few unique instances. While strong uptrends will almost always return an overbought reading and strong downtrends will almost always return and oversold reading, there are instances when these signals can prove extremely reliable to take a reversal or momentum trade.
Ideally, you should only consider this trading strategy in a range-bound market. To identify the trading range you can leverage tools, such as the Pricing Channels, or the Envelope Trading Indicators, such as the Bollinger Bands or Donchian Channels.
Once you have identified the trading range, executing this strategy is quite easy. You can enter momentum trades in these market conditions using the guidelines listed below –
- Go long when the security’s price is trading near the support line of its trading range and the RSI indicates an oversold condition.
- On the flip side, go short when the RSI indicates an overbought condition and the security’s price is hovering around the resistance line of its trading range.
Determining Stop Loss Target
Generally speaking, the Momentum Trading Strategy is primarily leveraged for short-term trading activities, such as – Day Trading. In such trading environments, setting stop-loss targets often need a different flavor, as it is more of a “stay the course” mentality that you are trading with.
However, the fundamental principle behind setting stop losses remain the same even with the Momentum Trading Strategy. That is –
- You set your stop loss a few points above the resistance line when taking a bearish trade. You do so to minimize the risk of heavy losses in case there is a breakout from the trading range.
- Similarly, in the case of a bullish trade, you would put your stop loss a few points below the support level to minimize losses in the event of a bearish breakout.
With that out of the way, for extremely short-term trading or scalping, most high-volume traders will likely want to set the stop losses for their trades at about .5% above or below their trade entry points to avoid losses associated with momentum petering out.
Finally, RSI readings moving into that 30-70 neutral range before the reversal happens is also a signal that the price may be breaking out of the trading range. It can therefore provide you with additional confirmation when deciding to exit a trading position to cut losses.
Determining Take Profit Target
With the Momentum Trading Strategy, as mentioned above, the price is generally range-bound when you enter a trading position. Therefore, with momentum trades, you should generally not expect to make profits that are as hefty as with the breakout or the reversal trades.
Generally speaking, a 5% return is a pretty good return for trades taken under this strategy, but the exact take profit targets would largely depend on the trading volume for the security that you are trading and your risk tolerance. Many day traders and scalpers that trade using this strategy, consider the 2% profit level a solid exit point.
That being said, you can leverage the following guidelines to determine the take profit targets under this strategy –
- In the case of a bearish trade, put your stop loss a few points above the support of the trading range. With these trades, when the price approaches your exit target, you can treat an oversold RSI reading as a signal of confirmation.
- Contrarily, in the case of a bullish trade, you should plan to exit your position to book profits when the price approaches the resistance of the trading range, and the RSI indicates an overbought market.
Advantages and Limitations of Trading Relative Strength Index (RSI) Indicator
Just like all other tools and indicators in technical analysis, the RSI (Relative Strength Index) has its own set of unique strengths and weaknesses. While it can be extremely beneficial to use the RSI when forming your trade hypotheses and trading decisions, you must not rely solely on this indicator and factor in its weaknesses in your trade decision-making matrix.
In the following sections, we will cover some primary pros and cons of trading with the RSI Indicator. The awareness and the incorporation of these factors into your overall trading strategy will allow you to make more informed and accurate decisions using this indicator.
Now, without further ado, let us dive deep into these strengths and weaknesses of the Relative Strength Index (RSI) Indicator.
Advantages of Trading Relative Strength Index (RSI) Indicator
Listed below are the primary advantages of trading with the RSI (Relative Strength Index) Indicator –
- The RSI Indicator is relatively easy to read and to comprehend for traders at all experience levels.
- When incorporated into the right trading strategy, in combination with other complementary analysis tools, the trading signals generated by RSI are quite reliable.
- The RSI serves as a great confirmation tool to estimate the probability of trend reversal for trade setups identified using other tools and analysis methods.
- On comparative terms, it is pretty easy to incorporate signals from RSI into an external trading system or strategy.
- It is an excellent tool of analysis for short term trading activities. Example – Day Trading.
Limitations of Trading Relative Strength Index (RSI) Indicator
Listed below are the primary limitations of trading with the RSI (Relative Strength Index) Indicator –
- The Relative Strength Index is not very reliable as a standalone indicator. This is because the markets do not always line up with the RSI readings.
- Even though the indicator helps determine whether a reversal in price trend is likely or not, it does not provide any indication of the exact reversal points.
- Strong trending markets can have a negative impact on oversold and overbought periods. Hence, your indicator might indicate an overbought condition and the price might continue to rise higher and higher, resulting in you missing out on golden profit-making opportunities.
- It is not uncommon for the RSI to not agree with signals generated by other technical indicators.
- RSI only focuses on the momentum of price changes, which is just one of the many factors that you should consider for profitable trading.
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Conclusion
The Relative Strength Index (RSI) Indicator is one of the most popular technical analysis tools used by traders today. Initially developed in 1978, this momentum oscillator has now evolved into several different variations, with each variation leveraging slightly different calculations and signal smoothing techniques. These variations allow trading experts to get an RSI reading that best meets the needs of their individual trading personality and market conditions.
When using the RSI Indicator to formulate a trade entry or exit plan, understanding what the readings measure and what the indicator scale reveals is essential. The Relative Strength Index (RSI) is primarily used to measure the momentum, and hence the strength, of a price trend. An indicator reading of above or at 70 indicates that the asset might be overbought and that its upward price trajectory might be artificially high. On the flip side, the RSI reading of 30 or below could be an indication that the asset is oversold or undervalued.
Even though the RSI (Relative Strength Index) Indicator is commonly used in technical trading, it is not very reliable as a standalone indicator for making trade entry or exit decisions. This indicator is best used as a confirmation tool to validate the trade hypothesis that you have formulated using other methods of security or asset analysis. That being said, traders often rely on RSI readings as their primary trigger for entering or exiting a trade. This is especially true for short term investors or day traders. In such scenarios, you can improve the accuracy of your trading decisions made using this indicator by incorporating other technical analysis concepts (such as – Support and Resistance, Candlestick Patterns, MACD, ADX, etc.) into your RSI trading strategy.
To effectively trade using the Relative Strength Index (RSI) Indicator, there are several key strategies that technical traders employ to better identify their trade entries, stop-loss targets, and take profit levels. The Breakout Trading Strategy, the Reversal Trading Strategy, and the Momentum Trading Strategy are the most popular of these RSI trading strategies and can be leveraged in both bull and bear markets.
Finally, as is true for all forms of analysis in capital markets, irrespective of how strong and thought through your RSI analysis is, nothing is guaranteed. However, by continually using the RSI and other tools to reevaluate your trading positions and by constantly reassessing your overall trading strategy, you are very likely to have a higher ratio of profitable trades over the long haul.
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