It is probably the most popular chart indicator found in any trading platform, often taught as a good technique to identify overbought and oversold conditions. Yet thousands of traders remain frustrated as they continue to lose money applying an RSI-based strategy. Why? They were taught how to interpret the RSI entirely wrong!
The RSI is a bounded oscillator, oscillating between 0 and 100, designed to measure the strength of price movements. In fact, despite its popularity, the traditional concept of being “overbought” or “oversold” has led many a trader astray. Many blindly buy when the RSI dips into “oversold” territory or sell when it hits “overbought,” then watch in dismay as the market moves against them.
This article will expose the RSI indicator scandal and reveal the right way to use it. By understanding the dominant market energy and properly timing your trades, you can reverse your losses and make use of the RSI on your terms. Let’s uncover the truth!
Why the “Overbought/Oversold” Concept Fails
One of the biggest myths in trading is that RSI’s overbought (above 70) and oversold (below 30) levels indicate impending reversals. This approach assumes:
- Oversold = Buy Opportunity: The market is allegedly too “cheap” and due to go higher.
- Overbought = Sell Opportunity: The market is allegedly too “expensive” and due to fall.
This approach fails in trending markets, however. When RSI shows over-sold levels, it often reflects strength to the downside, not a reversal signal. Overbought levels indicate strength to the upside, not a shorting opportunity. Frequently, traders who base their recommendations on this false concept find themselves trading against the dominant market trend consistently.
Awareness of the Dominant Market Energy
RSI should be traded in the direction of the dominant energy of the market. Here’s how:
- Recognize Strength: When RSI hits extreme levels (near 30 or below for a downtrend, 70 or above for an uptrend), it reflects the market’s dominant energy. In a strong downtrend, oversold RSI indicates powerful bearish momentum.
- Avoid contrarian traps: That is, buying into oversold conditions or selling from overbought conditions typically guarantees a loss. So stick to the trend of your trades. If it is a bearish market, for instance, favor getting confirmation by the trade going to oversold levels of RSI, and get out to short for temporary pullbacks.
- Weakness vs. Strength: Weakness is indicated when RSI fails to move to extreme levels (for example, it cannot reach 70 in an uptrend or cannot drop below 30 in a downtrend). This lack of energy commonly precedes a possible change in the trend.
How to Trade the RSI the Right Way
Step 1: Identify the Dominant Trend
Use RSI as a momentum indicator to confirm the market’s dominant energy.
- In an uptrend: RSI is constantly above 50, and the pullbacks infrequently fall below 40.
- In a downtrend: RSI continually lingers below 50, and rallies cannot push past 60.
Step 2: Wait for a Pullback within the Trend
- Within a downtrend, wait for RSI to rise a little, signaling a weak retrace to the upside. Short when RSI starts to roll back down.
- In an uptrend, watch for RSI to dip temporarily, signaling a weak bearish pullback. Enter long when RSI turns upward again.
Step 3: Combine RSI with Price Action
Price action provides context for RSI readings. For example:
- In a downtrend, when RSI reaches oversold levels, confirm with price making lower highs and lower lows before entering a short trade.
- In an uptrend, when RSI goes overbought, confirm with price making higher highs and higher lows before taking a long trade.
Step 4: Trade RSI Divergences Caution
Divergence from price and RSI works well in weak trends or sideways markets. However, always remember to trade with the trend of dominant energy.
Timing your Entries with RSI
The RSI gives insight into momentum but does not provide exact entry or exit points. To get rid of the limitation:
- Use a timing indicator to accompany the RSI, such as moving averages or candlestick patterns, in order to fine-tune your entries.
- Focus on entries that support RSI signals with key levels of support or resistance in price action.
Real-Life Example
Consider a strong downtrend where RSI continually drops below 30. On this sort of market, the trader dependent on traditional interpretation of RSI may keep buying each time RSI hits oversold only to have the market continue lower.
On the other hand, since you know that an oversold RSI typically shows the strength is going down, you can:
- Wait until RSI rises modestly (a weak retrace).
- Watch for price to make a lower high during the retrace.
- Enter a short trade as RSI starts to decline again, in line with the predominant bearish trend.
Why Most Traders Fail with RSI
The very fact that the RSI is bounded between 0 and 100 makes extreme readings often a sign of maximum strength of the trend, rather than the exhaustion. It is for several reasons:
- Misleading teachings that insist overbought/oversold kind of logic.
- They do not understand momentum and trend strength.
- Using RSI in isolation from price action or other confirmation tools.
Conclusion
The “RSI Indicator Scandal!” sheds light on how the traditional teachings about RSI have been misleading traders for years. Flip the narrative and use RSI to affirm the dominant market energy so you can trade in harmony with momentum rather than against it.
Key Takeaways:
- Ignore overbought/oversold myths.
- Always trade in the direction of the dominant market energy.
- Use RSI as a momentum tool, not a reversal indicator.
Start applying these today and watch how trading will transform for you. Add that extra edge, use the RSI in combination with a good timing indicator for more pinpointed entries and exits.
