The ( ) is a very popular and often used indicator that can be used effectively in many different ways. My personal favorite two are:
1. As a tool to indicate a reversal. This is the most popular way.
2. As a . This is what it was designed for.
Below we will discuss how to read the , and how to set it properly depending on market conditions.
What the numbers mean
Before we discuss what to do with the information that the gives us, we should learn what the numbers mean.
The is a line graph that moves from 0 to 100. When the is 70 or over, we consider our crypto to be overbought (people bidding up the price). Then when the is 30 or below, we consider our crypto to be oversold (people bidding down the price).
Overbought means that the crypto might be overvalued.
Oversold is the reverse. The crypto might be undervalued.
The actual number is calculated using the average gain or loss over a set period of time. The default time period is 14 (minutes, hours, days, based on how the chart you are currently looking at is set).
You could also set your period length to a lower number, I use 10 sometimes, so that the is more sensitive to recent moves. This is good to do in markets that are highly volatile (crypto for example).
The actual number will increase as there are more and more positive closes within your time period, and will fall as there are more and more negative closes within your time period.
As with every trading indicator, the should not be used as the sole reason for a trading decision. It helps paint a picture of the market of the particular crypto you’re looking at.
Nor are the default values always to be used. We’ve discussed time changes, but you could also change the upper and lower bands.
In a bull market you may want to change the upper band to reflect the general trend of the market (more on that later).
Now, let’s about how to actually use the . The first way to use it is as a way to spot a possible trend reversal.
Put simply, the can help us see if we have, in the last few candles, changed from an up-trend to a down-trend, or from a down-trend to an up-trend.
When the is below 30 and crosses up, we consider this a move.
When the is above 70 and crosses down, we consider this a move.
Just to reiterate: A cross up is not an automatic buy, just as a cross down is not an automatic sell. As you can see below.
But it is pretty accurate.
Nothing in TA is 100%, but the closer you get to 100% the better trader you will be.
One other thing to note based on the above picture is that there was no time that the dipped below 30. In a crypto bull market (which we are currently in) it is more common to see cryptos that are overbought as opposed to oversold. You can compensate for this by changing the oversold line to 40 .
Additionally, as the crypto moves up in price, you can see the making consistent higher lows.
One thing to look for when you are trying to spot trend reversals is what is called a .
This means that the price of your crypto is in a downtrend and making lower lows. At the same time, the is oversold and is making higher lows.
When you spot this, it can be a very powerful indicator that the trend is reversing to the upside.
A divergence is the same thing but in reverse. The price of the crypto is getting higher and higher while the is overbought and making lower highs.
RSI as a momentum indicator
Another way to effectively use the is by using it for its intended use as a .
As we talked about before, the rises as we have more and more positive closes in our time window. It rises more (faster) when the price movements are more extreme to the upside. The reverse is true for the downside.
So, if we are oversold that means there is momentum to the upside, and if we are overbought that means there is momentum to the downside.
Generally, it is better to trade with the momentum than against it. Unless we spot the reversal signals that we discussed above; crossing back down, or crossing up.
It is also better to go long in bull-markets and short in bear markets when using the in this way.
Let’s take a look at the chart below:
In a bull market the 50-60 range of the acts as support and the usually stays above 40 .
I like to set my upper band to 60 in a bull market so I can trade with the momentum and spot potential reversals in the 50-60 range.
As you can see it is necessary to use the differently in different market conditions.
As you can see there are different ways of successfully using the . I hope I’ve made at least two of those ways clear in this beginner guide.
Please let me know if you have any questions and if you like it, please hit the thumbs up and be sure to follow for more!
Thanks for reading!
I wish I had a better answer on how to avoid those trades altogether but even if you get in a trade under perfect conditions there are no guarantees you won't get faked out. Most fakeouts happen because of news events that rapidly shift market conditions. All you can really do is to give yourself an edge over the market. Since I don't know, and I'm not sure anyone does, how to avoid the trades totally the next best thing is to not lose money. I do have a system I use to manage risk.
What I like to do though is to set stops. Not stops on the price but stops on the RSI (trading view has alerts for this). For example, looking at the last chart at the 'Failure', I usually won't get out of a trade until the RSI closes a candle under 50. Remember this is in bull-market conditions (I like the 50-60 range as support). That trade would not have lost money. Just opportunity cost for those three days.
Also, the breakout on the 28th of February (still last chart), would not have been a good entry point because the RSI only got to about 63. I don't think that is really 'decisive'.
Your question made me realize that I need to establish a better way to enter the momentum trades. I need to define what a 'decisive breakout' would be.
See, the idea behind these trades is to get in and ride the wave until the market really cools off. This is done using the RSI and not price because the RSI will stay elevated (over 50 for these trades) during periods of consolidation - see Feb 5th - Feb 8th. Staying in would have been great here because ADA still had room to run up.
I hope all that made sense and clarified a few things. I can't post new charts as comments (I think) so I hope I was clear. Thanks again for your question. I think making those rules will make me a better trader!
Another question that I have is when you see a 'decisive' break of the overbought level, do you enter right on the candle closure and the next candle open? Bearing in mind that price could be a strong impulse move and have traveled a lot higher on entry with this method, but I suppose it prevents fake out. On your mention of defining what is a decisive break maybe it could be reaching level 65/70 when the actual level is 60?
Similar to the momentum trade, for a reversal signal do we need a solid ('decisive') entry back into normal territory (30-70 normally) from an overbought/oversold zone before we take a trade.
Another indication that I like to look out for is if there is room to the left. The last thing you want to do is to get into a trade where the upside is limited by a nearby resistance level. One reason the ADA graph looks so good is that there was a lot of room to run for that trade.
I like the idea of 65-70 but I'll have to look at the charts to see if that is the best range.
My thoughts on your second question are the same. Better to get into something that you're more confident in rather than having your money tied up. However, if you're using the reversals to exit a trade, you'll want to be more focused on price. Remember that the RSI is determined by price, not the other way around. One strategy you could use is to move your stops up as you are more positive in a trade. Now we are getting into the territory of your personal comfort with risk and how hands on you want to be.
They comprehend each other, ascertain over bought - oversold wella...