When is a trade profitable? Only if both the purchase and the sale are conducted at the right time. It is a common experience for traders to experience profits evaporating (or even incur losses) due to selling too early or holding on to the trade even after the trade changes. A tool that enables traders to spot trend reversals is the relative strength index (RSI), which helps them avoid buying at the tops and selling at the bottoms.
The Fundamentals of RSI
The relative strength index (RSI) is a momentum indicator that is utilized in technical analysis to measure the magnitude of recent price changes in order to evaluate the strength of the current market. It is displayed as an oscillator and can have a reading from 0 to 100.
An asset is considered overbought when it exceeds its intrinsic value, either in the short term or long term. This might indicate that this particular asset could be at risk of being corrected. In the same vein, an asset that is trading at a price below its intrinsic value is considered oversold. This might suggest that this particular asset is ready for a rebound.
If the RSI trades between 50 and 100, it is assumed to favour the bulls. Contrariwise, if it is between 0 and 50, it implies that the bears have an advantage. An RSI reading of 50 is considered neutral which means that there is a balance between the bulls and the bears.
On most charting softwares, the default setting designated is that a reading exceeding 70 is considered overbought, whereas a reading below 30 is oversold. That being said, if traders only use these values to guide them in their purchase and sale, it is probable that they buy too early during a bear phase and sell during the early stages of the bull phase.
Thus, it is significant to grasp how to use these overbought and oversold readings in order to maximize profits
Here are some examples to help us better understand these concepts:
As illustrated by the chart above, Binance Coin (BNB) broke above its previous all-time high, starting the next leg of its rising trend in February this year. The coin was valued at $52 when the RSI exceeded 70, implying that it was overbought. Traders who sold at this point most probably missed a large sum of their future profits.
Bear in mind that when a coin begins a new uptrend by breaking out of a range or critical resistance levels, the probability of the RSI still being overbought is high. This is due to the fact that professional traders acknowledge the start of a new uptrend and begin purchasing without waiting for a dip. As there is sustained buying, the RSI remains in the overbought territory for a considerable duration. Thus, in this example, the position should not be closed just because it exceeded above 70.
Spotting Overbought Conditions
If the RSI exceeds 85 during this early period, you should be cautious. As seen in the chart above, on Feb. 19 the BNB/USDT pair illustrates that the RSI rose above 95 on Feb. 19 when the price reached a local high at $348.70.
Thereafter, altcoin corrected 46% to $186.10 on Feb. 23. During these stages of frenzied buying, it is hard to forecast a top, therefore, traders must tighten their stops in order to protect the profits they acquired when the RSI rose above 85.
On April 12, the RSI again jumped above the 85 level, making a local top. This implies that traders should remain vigilant as the RSI reaches 85 even during strong bull periods.
Another thing to note is that during the months of February until mid-May, the RSI never dipped into being oversold. During bull periods, the RSI usually takes support between 40 and 50. When the price dips between these levels, traders should become wary and seek other supporting signals to initiate long positions.
As shown above, Bitcoin (BTC) began its uptrend in October 2020. Take a look at how the RSI jumped and remained above 70 during the early days of the bull run. That being said, the RSI did not reach the extremely overbought zone above 85 during this time.
It was in January when the RSI rose above 85. Traders who initiated a sale during this period caught a local top. As the price corrected, the RSI dropped to close to 40, offering a buying opportunity to traders.
In November 2020, Ether (ETH) also started its bull run, however, the RSI did not sustain in the overbought territory. The RSI exceeded 85 only in early January. Traders who sold at this period would have had profits this early. This only means that there is no indicator or strategy that is guaranteed to work every time.
When the RSI dropped to 40, traders got two more buying opportunities. This would have enabled them to re-enter the market and leverage the remaining bull run.
On May 11, the RSI reached 83.46, just shy of the 85 mark and the biggest altcoin topped out on May 12. This illustrates that the 85 level is no magical figure and that traders should be careful when the price nears the mark.
Given that RSI is a momentum oscillator, there is an assumed direct relationship between the price as well as the RSI—when price rises, so should the RSI. However, there are cases when the RSI diverges from the price action. During these situations, even when the price increases, the RSI fails to do so.
This phenomenon is called negative or bearish divergence which is a warning sign that the bullish momentum may be weakening.
Based on the chart above, the RSI reached a high above 89 as Bitcoin rose to a new all-time high at $41,950 on Jan. 8. Even so, as Bitcoin kept on making higher highs, the RSI continued to make lower highs. This was an indication that the bullish momentum was waning.
When a negative/bearish divergence forms, traders should be vigilant and wait for the price to react downward before initiating a sale. In this scenario, the breakdown below the 50-day simple moving average or the RSI dropping below the 45-mark signalled that the trend may have ceased.
Polkadot (DOT) is another example where the negative divergence caused a sharp fall. However, in this particular example, the RSI did not give a sell signal. Always bear in mind that it is very important to not rely on one indicator alone. A break below the moving averages suggested that the trend was changing. Traders could have sold at that time as the RSI was already signalling weakness in momentum.
Spotting divergences is essential
The RSI is an essential tool that can help signal the end of a bull phase. Extreme readings in the overbought territory as well as negative divergences both can also be utilized to book profits on positions before the trend changes. Instead of trying to time the top, traders should consider selling when the RSI and moving averages suggest that the trend is waning.
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