WHAT IS THE RELATIVE STRENGTH INDEX?
The relative strength index (RSI) is a momentum indicator which helps to show when a market is overbought or oversold.
WHAT IS AN OVERBOUGHT MARKET?
“Overbought” is a market condition where a move higher becomes extended to such an extent that buying interest becomes exhausted. Effectively, there is no one left prepared to buy at increasingly higher prices leaving the financial instrument vulnerable to a sell-off. This selling can become severe and accelerate as holders of long positions rush to book profits or cut losses.
OVERSOLD MARKET DEFINITION
Here’s the RSI sitting underneath the EURUSD chart. We can see how the index briefly tipped above 70 suggesting that the currency pair was overbought. This proved to be the case as the EURUSD subsequently declined. The RSI then fell below 30 indicating an oversold market, and it wasn’t long before the euro bounced sharply before settling in to a relatively narrow trading range. It is worth noting that the RSI remained below the oversold 30 area for quite some time and the EURUSD continued to decline over this period. In contrast, the RSI only briefly broke above 70 before the market sold off. So there’s no hard and fast rule over how quickly one should react to breaks above 70 or below 30. Consequently, many traders also employ additional indicators or drawing tools to help them identify actionable trading signals.
In common with other oscillators (such as the MACD), a divergence between the trend in the RSI and in price can also highlight trading opportunities. Here’s an example where the price of the EURUSD is pushing higher, making a succession of higher highs and higher lows.
Typically this would suggest that the currency pair is in a bullish trend and that the correct trade would be to buy on any pull-back. However, this move isn’t confirmed by the RSI which is showing divergence, putting in a succession of lower highs. This tells us that the buying momentum is declining and that the trend could be about to reverse.
As we can see, that’s exactly what happened. Instead of trending higher the EURUSD sold off. Not only that but it struggled to find any support, despite the RSI indicating that the market was oversold on a number of occasions. In this instance, the RSI would not only have warned you not to trust an apparent uptrend, but it would also have signalled a solid selling opportunity. But it’s worth noting that it didn’t help to identify an accurate point to close out the short. Once again, this shows the importance of using more than one indicator when picking your entry and exit levels. So use the RSI in conjunction with other indicators as well as with drawing tools such as Bollinger Bands, simple support and resistance lines and perhaps a trend-following drawing tool such as Andrews’ Pitchfork to help identify trading opportunities.