The Relative Strength Index is one of the first indicators that traders will encounter. It is a momentum indicator that was created to tell traders and technical analysts in figuring out the change in a security’s price movement and its speed over a specific period of time.
One of the primary uses of the Relative Strength Index is to help a trader point out certain overbought and oversold conditions in certain trading sessions a security or asset. It helps one come up with a measurement on rallies and plunges in a trading session. The most basic explanation for RSI is that it helps a trader figure out if the condition is overbought or oversold.
Two terms that one needs to know when understanding the relative strength index is overbought and oversold. Overbought is when a specific period of time experienced an extended and consistent gain and increase in the price. This significant upward trend also lacks the presence of a fallback or a sudden decline. It is the constant upward trend that leads to the price being susceptible to a sudden decline. In technical analysis’s, the term is used to call the situation wherein a price has reached a high volume. One way of figuring out if the price has reached an overbought level is when an oscillator reaches the upper line.
Oversold, on the other hand, is when there has been a constant decline or downward trend in a period of time without a lot of pullbacks. While an overbought price might lead to a sudden decline, an oversold price is vulnerable to a rally but it is important to keep in mind that a price can remain overbought or oversold for a prolonged period of time, this is when an oscillator can be used to help figure out if a sudden pullback might happen.
One of the advantages that the RSI can provide is that it easily tells a trader if a certain price is overbought or oversold. The RSI going beyond the 70 level will instantly give an overbought while the RSI falling below the 30 line will show an oversold reading.
What ‘Overbought’ and ‘Oversold’ can tell traders.
Before one will enter a certain trade and a decision is made based on the Relative Strength Index, a trader must make sure if a certain trend or the current price will not eventually lead to a sudden rally or decline in prices anytime sooner.
The chart below will show that the RSI has just risen above the 30 level. This is clearly not an overbought price so a sudden drop in prices will likely not occur soon so it is a signal for a ‘buy’ since the line has just broken out of an oversold level 30. When the RSI goes beyond level 70, it is already overbought and will be already heading on a downward trend. A rally that clearly shows the RSI nearly breaking out of the level 70 is a ‘hold’ sign where traders should wait for the RSI to cross under the 70 again before selling.
After an overbought leads to a decline in the prices, a ‘sell’ signal is on. Selling the stock while it is above 70 will lead to an overbought since there is no indication how high the prices could get. So it is only safe to sell when the RSI dips below the level 70. That will give a trader a higher chance of a positive trade outcome.
The relative strength index is a very useful indicator and one popular tool in a technical analysis. Aside from showing overbought and oversold prices, it also can give buy and sell signals with potential positive returns. It can easily show price movement which can inform you of possible reversals. One way to improve one’s RSI reading is to watch out for the difference between the price and the RSI indicator as this can mean a sudden reversal and can give unclear signals to confirm the current position of the price or its direction.
Although it can easily show price movement, traders must also be very careful as little details can create the wrong buy or sell signals. It would best work for the trader to use RSI along with other technical indicators.