RSI is one of the most widely followed technical indicators out there.
The focus of this writeup is on understanding the overbought and oversold readings. I am not delving into the details of calculation and divergences.
So what does overbought reading mean?
An above-70 reading on the 14-day RSI is widely considered an overbought reading.
Many people consider overbought reading as a sign of bearish reversal. That is a so wrong…
An above-70 RSI only means the underlying asset’s price has rallied too fast… too soon and the momentum may slow or stall for some time.
Also, the price needs to validate the overbought readings, i.e. the above-70 reading on the RSI becomes valid only if signs of buyer exhaustion appear in the form fo candlestick patterns like a hanging man, bearish hammer, bearish engulfing or outside day or simply a candle with a long upper shadow.
Also, failure on the part of the bulls to push through a certain level would validate overbought reading on the RSI.
A trader should take overbought reading on the RSI seriously if the market is at record highs or at multi-year highs.
That said, traders should ignore overbought readings on the RSI as long as the price is showing no signs of buyer exhaustion.
In fact, if prices are rising on the back of strong volumes, then I consider an overbought RSI as further evidence of trend strength.
Example of reading the overbought reading on RSI
Lets say a stock has rallied 10-15% in just few days and now the RSI is holding above 70.
First I would check if the price is showing signs of bullish exhaustion. Lets say, there is a doji candle – a sign of buyer exhaustion (indecision after a solid rally).
So what we have now is buyer exhaustion on price + an overbought reading on the RSI.
In this case, I would exit my longs and check for the following day’s close. It its above the doji candle’s high and on the back of strong volumes, I would ignore RSI and go long.
If the close is below doji candle’s low, the RSI gains credence and I go short with stops above the doji candle’s high or as per my risk appetite.
On similar lines, oversold readings on the RSI gain credence only when the price is flashing signs of seller exhaustion in the form of doji, long-legged candle or doji candle, bullish engulfing, inverted green hammer, bullish outside reversal or repeated defense of a specific level.
I hope this write up was helpful. Let me know if you want me to make a video or write up in more detail on RSI or other indicators or macros.
The focus of this writeup is on understanding the overbought and oversold readings. I am not delving into the details of calculation and divergences.
So what does overbought reading mean?
An above-70 reading on the 14-day RSI is widely considered an overbought reading.
Many people consider overbought reading as a sign of bearish reversal. That is a so wrong…
An above-70 RSI only means the underlying asset’s price has rallied too fast… too soon and the momentum may slow or stall for some time.
Also, the price needs to validate the overbought readings, i.e. the above-70 reading on the RSI becomes valid only if signs of buyer exhaustion appear in the form fo candlestick patterns like a hanging man, bearish hammer, bearish engulfing or outside day or simply a candle with a long upper shadow.
Also, failure on the part of the bulls to push through a certain level would validate overbought reading on the RSI.
A trader should take overbought reading on the RSI seriously if the market is at record highs or at multi-year highs.
That said, traders should ignore overbought readings on the RSI as long as the price is showing no signs of buyer exhaustion.
In fact, if prices are rising on the back of strong volumes, then I consider an overbought RSI as further evidence of trend strength.
Example of reading the overbought reading on RSI
Lets say a stock has rallied 10-15% in just few days and now the RSI is holding above 70.
First I would check if the price is showing signs of bullish exhaustion. Lets say, there is a doji candle – a sign of buyer exhaustion (indecision after a solid rally).
So what we have now is buyer exhaustion on price + an overbought reading on the RSI.
In this case, I would exit my longs and check for the following day’s close. It its above the doji candle’s high and on the back of strong volumes, I would ignore RSI and go long.
If the close is below doji candle’s low, the RSI gains credence and I go short with stops above the doji candle’s high or as per my risk appetite.
On similar lines, oversold readings on the RSI gain credence only when the price is flashing signs of seller exhaustion in the form of doji, long-legged candle or doji candle, bullish engulfing, inverted green hammer, bullish outside reversal or repeated defense of a specific level.
I hope this write up was helpful. Let me know if you want me to make a video or write up in more detail on RSI or other indicators or macros.