Strength Index (RSI) is a technical indicator that tries to gauge the strength
or weakness of a particular instrument based on a formula that tracks past
prices during a custom period. This makes the RSI a momentum indicator because
it measures the speed of price movements compared to previous periods to
forecast possible inflection points.
The RSI is
measured on a scale from 0 to 100 and a default period of 14 most recent
closing prices. The RSI is also said to be in overbought or oversold territory
whether it crosses the 70 or 30 levels respectively on the scale. The idea
behind it is that the price can’t sustain the momentum at such extreme levels
and, even if it doesn’t mean a change in trend, the price may be bound to a
correction so a trader may want to wait before entering at such extreme levels or
even take a counter-trend trade.
The problem
with this idea is that the RSI can stay in overbought or oversold territory for
a long time and even if pullbacks may occur, they may be really shallow, and
the real correction may take a long time. Below you can see how the RSI stayed
in overbought territory for four months (!) before giving a real correction.
That’s why
you shouldn’t use the RSI on its own but complement it with other technical
concepts and tools to better structure your trades. For example, in the
previous image of the RSI staying in overbought territory for four months, if
you wanted to take a short you could wait for the price to first break an
upward trendline or for moving averages to cross to the downside to “confirm”
your trading idea. On the other hand, if you wanted to take long positions,
then you could wait for price pullbacks to the moving averages before entering
for a continuation to the upside.
This way you
increase the probabilities in your favour and can avoid being too early or too
late to price movements. Moreover, you should be aware of the fundamental
picture and see if it confirms the technical picture. Once you get a meaningful
catalyst that catches the market attention, you can see the price moving up fast
or down like in the previous chart.
This article
was written by Giuseppe Dellamotta.