You might be wondering what type of technical tools you should use when analysing and trading the markets. The selection is quite wide-ranging from moving averages to different oscillators, to support and resistance levels and to Bollinger Bands. Just to mention a few.
Some traders try to solve this problem by inserting several moving averages and Bollinger Bands as well a varying number of oscillators on their charts. The result however is a chart that is difficult to read due to too many indicators. There’s just too much information for the human brain to evaluate. In addition, some of the indicators are bound to contradict the message from some of the other indicators. Therefore, the decision-making process becomes ineffective. This is clearly not the way to do analysis. Instead, it makes sense to stick to only one or two indicators that are carefully selected.
In this article, I give you some ideas on how to use the RSI in trading.
Oscillators like RSI can be very helpful when trading sideways markets or so-called trading ranges. However, if you try to use oscillators in trending markets in a similar manner they will produce losses. We need to understand what type of market we are trading in. Trending markets are quite different from ranging markets. No indicator can produce desired results in so different environments.
When the price is moving within a trading range the market participants are in a relative agreement that the price within this range represents a fair valuation of the market in question. In other words, all the factors impacting the price at the given moment are in a relative balance. Under these circumstances, no market participant is willing to push the prices beyond the limits of the trading range. In technical analysis, we call these limits support and resistance levels.
When a market is ranging it means that it has clearly defined support and resistance levels and the price keeps on bouncing off from these levels. The price, for instance, rallies to a resistance level and once the move has been rejected it starts to fall towards the centre of the range. If the price then moves to the other extreme of the range and touches the support it is more likely to reverse and again move towards the centre of the range.
The centred indicators like the RSI (Relative Strength Index) are designed to revert to the mean. This is why they reverse once they move the extremes of their range. This is also why oscillators can be a good tool when trading in price ranges. Ranges, after all, are mean-reverting by their nature.
Indicators like RSI provide a clear visual alert when the price is bouncing either from a support or a resistance level. However, when the price is trending higher centred oscillators tend to fluctuate around the upper end of their ranges. This gives multiple false sell signals and traders who don’t know what they are doing tend to lose money. The same happens with downtrends. Newbie traders try to buy as oscillators move to the lower extremes.
The upper end of the range in RSI is known as an overbought zone while the lower extreme is called an oversold zone. This is one of the reasons why new traders who don’t know how the oscillators work in trending markets tend to be selling the rising markets and buying the markets that trend lower.
When the market is ranging some traders buy as soon as the price moves close to the lower end of the price range and the RSI is oversold (below 30 points in RSI) while the others look for a reversal in the indicator before entering a long trade. When price rallies to or near the resistance level traders tend to do the opposite. They either sell as soon as the indicator moves into the overbought zone (above 70 points in RSI) or wait for the indicator to start reversing. You need to remember that eventually every price range is violated and the price starts to either rally or fall. This is why you need to always have a protective stop loss in place. As a rule of thumb the closer the stop the bigger the probability of price hitting the stop. You should therefore think carefully about where you place your stops and how much you will risk per trade.
Please remember that in order to make sure you are comfortable using this approach you have to do your own research and see if you can rely on this strategy idea. We do not suggest you will apply this strategy without a thorough backtesting or forward testing on your part.
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Chief Market Analyst
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