How to Use Relative Strength Index (RSI) in Trading
Experienced traders know that the Relative Strength Index (RSI) is one of the most popular trading signals for identifying trend reversals with overbought and oversold conditions. However, what are some of the typical scenarios a trader might encounter when using RSI to predict short-term price movement, and how should you react?
In this blog, we’ll explore how to use RSI when trading and how you can use it to make better trading decisions.
Scenario 1: Spotting Hidden Weakness with Bearish Divergence
Let’s say a crypto asset like Bitcoin has been on a steady uptrend. It continues to make higher highs, but you notice something interesting on the chart: the RSI is forming lower highs. This is a classic example of bearish divergence.
While the price appears strong on the surface, the underlying momentum is waning, a sign that the bulls are losing control, and a trend reversal might be imminent.
You might consider taking a defensive stance, tightening your stop-loss orders on existing long positions, or even consider taking profits. If the price breaks a key support level and the RSI confirms the weakness, it could be a signal to initiate a short position.
Scenario 2: Identifying Emerging Strength with Bullish Divergence
Now, consider a crypto asset that's been in a downtrend. The chart trendline shows it making lower lows, but the RSI is forming higher lows.
Despite the downward price action, the selling pressure is weakening, indicating that the bears are losing their grip, and a potential trend reversal could be brewing.
A bullish divergence is a potential buying opportunity. You might start looking for potential long entries, especially if the price bounces off a key support level and the RSI breaks its downtrend line.
Scenario 3: Riding the Momentum with Failure Swings
Let's say the RSI surges above 70, signaling overbought conditions. However, instead of reversing, the price continues to climb, and the RSI retraces slightly before pushing higher again, also known as a bullish failure swing.
The bulls are in control, and the uptrend is likely to continue. The temporary dip in the RSI represents a pause in the momentum, not a reversal.
This scenario can be a good opportunity to add to existing long positions or initiate new long positions if the price breaks out to new highs with increasing volume.
Scenario 4: Navigating Choppy Markets with RSI Ranges
Ranging markets can be tricky. Prices oscillate between support and resistance levels, making it challenging to identify clear trends. However, the RSI can be a valuable tool for spotting potential entry and exit points within these ranges.
What to look for:
Identify the range: First, clearly define the support and resistance levels that form the boundaries of the range.
Look for RSI extremes: Pay close attention to how the RSI behaves as the price approaches these boundaries.
When the price touches the support level, and the RSI drops below 30 (oversold), it could signal a potential long entry. Look for the RSI to form a bullish reversal pattern (e.g., a higher low) for further confirmation.
Conversely, when the price reaches the resistance level, and the RSI climbs near or above 70 (overbought), it could indicate a potential short entry. Look for the RSI to form a bearish reversal pattern (e.g., a lower high) for added confirmation.
Combine with other indicators: Don't rely solely on the RSI. Use other technical analysis indicators like moving averages, volume, and candlestick patterns to confirm your signals. For example, increased buying volume as the RSI bounces from oversold territory can strengthen the case for a long entry.
Combine the RSI with support and resistance levels to identify high-probability trading zones.
Scenario 5: Confirming Breakouts with RSI
Breakouts occur when the price moves decisively through a key support or resistance level. The RSI can help you confirm the validity of these breakouts and filter out false signals.
Identify key levels: Clearly identify the significant support and resistance levels on the chart.
Observe RSI behavior during the breakout:
For a bullish breakout, look for the price to break above the resistance level with increasing volume and the RSI to surge above 70, indicating strong buying momentum.
For a bearish breakout, look for the price to break below the support level with rising volume and the RSI to drop below 30, suggesting strong selling pressure.
Beware of false breakouts: If the price breaks a key level but the RSI fails to confirm the move (e.g., it stays below 70 on a bullish breakout or above 30 on a bearish breakout), it could be a false breakout. Exercise caution in these situations.
Once a breakout is confirmed, use trailing stop-loss orders to protect your profits as the price moves in your favor.
Trading Indicators to Use with RSI
While the RSI is a powerful tool on its own, combining it with other technical analysis indicators can significantly enhance its effectiveness and improve your trading decisions. By incorporating complementary indicators, you can confirm RSI signals, filter out false signals, and gain a more comprehensive view of the market.
Some common technical analysis indicators that work well with the RSI include:
1. Moving Averages:
Why it's good: Moving averages help identify the overall trend direction and potential support and resistance levels.
Benefits of combining with RSI:
Confirming trend reversals: When the RSI shows divergence and the price breaks a key moving average (e.g., the 200-day moving average), it strengthens the signal for a potential trend reversal.
Identifying entry points: Use moving averages in conjunction with RSI overbought/oversold signals to pinpoint potential entry points. For example, a long entry could be considered when the price bounces off a support level (confirmed by a moving average), and the RSI shows a bullish reversal from oversold territory.
2. MACD (Moving Average Convergence Divergence):
Why it's good: The MACD is a momentum oscillator that shows the relationship between two moving averages. It helps identify changes in trend strength and direction.
Benefits of combining with RSI:
Confirming momentum shifts: When both the RSI and MACD show divergence, it strengthens the signal for a potential trend reversal.
Filtering out false signals: If the RSI shows an overbought/oversold signal but the MACD doesn't confirm the momentum shift, it could be a false signal.
3. Trading Volume:
Why it's good: Trading volume reflects the intensity of trading activity. Increasing volume often confirms the strength of a price movement.
Benefits of combining with RSI:
Validating breakouts: When the price breaks a key level with increasing volume and the RSI confirms the move, it increases the likelihood of a successful breakout.
Confirming trend reversals: Rising volume accompanying RSI divergence can strengthen the signal for a potential trend reversal.
4. Candlestick Patterns:
Why it's good: Candlestick patterns provide visual clues about potential price movement reversals and continuations.
Benefits of combining with RSI:
Confirming reversal signals: When the RSI shows divergence and a candlestick pattern (e.g., a doji or engulfing pattern) forms at a key level, it reinforces the signal for a potential reversal.
Identifying entry points: Use candlestick patterns in conjunction with RSI overbought/oversold signals to pinpoint potential entry points.
How to Trade Cryptocurrencies on Flipster
Sign up for an account on the Flipster website or by downloading the Flipster app (Android or Apple).
Click the [Trade] tab.
Search for your preferred cryptocurrency and click on it.
Select the leverage (up to 100x).
Select either a Trigger Order or Market Order.
Enter the amount of coin you want to trade or choose a percentage of your available funds.
Once you have confirmed the details, click the [Long] or [Short] button to open a position.
Disclaimer: This material is for information purposes only and does not constitute financial advice. Flipster makes no recommendations or guarantees in respect of any digital asset, product, or service. Trading digital assets and digital asset derivatives comes with significant risk of loss due to its high price volatility, and is not suitable for all investors.