Momentum indicators are widely used by commodity traders to measure when a market is overbought or oversold. They're often a critical component of trading arsenals for traders who live by the old adage, "Buy low, sell high."
- The Relative Strength Index (RSI) is a momentum indicator that measures the overbought or oversold levels of the market.
- A reading of 70 or higher typically indicates the market is overbought, while anything 30 and below means the market is oversold and might be due for a rally.
- An effective way to use the RSI is to follow the trend and enter the market during pullbacks, when there is a solid support or resistance level.
- You can adjust the parameters on the RSI to suit your trading style.
Relative Strength Index
The Relative Strength Index (RSI) is one of the more popular momentum indicators and it's probably among the easiest to use. It measures the overbought or oversold levels on a scale of 1 to 100. The common setting for the RSI is 14. This means it tracks the last 14 periods, whether those periods are days or 5-minute bars on a chart.
The main thing you want to watch out for are readings above 70 or below 30. When the RSI is above 70, it means the market is overbought and likely due for a correction. When the RSI is below 30, the market is getting oversold and might be due for a rally. Of course, these numbers should only be used as a gauge to help you in your buying and selling decisions, not as a trading system.
Trading With the RSI
Many books have been written on trading with momentum indicators and the RSI, and there are multiple theories on doing so. Some methods simply aren't effective, but many traders successfully use the RSI in their own unique ways.
One of the best ways to use the RSI is to follow the trend and enter the market on pullbacks within a trend. First, identify a trending market. If you find a market that has been trending higher, the RSI will probably be near an overbought level of 70. You would look for a buying opportunity when the market corrects when the RSI reaches an oversold level near 30.
This method is an easy way to identify buying opportunities in trending markets. The RSI will ideally prevent you from chasing a market that's in an overbought condition. Your risk is much lower if you buy a bullish market when it's not in an overbought state. This trading method also helps a trader exercise patience and discipline.
Many novice traders can't stand to sit back and watch a market run higher. They inevitably chase the market and often enter at the high for the move.
A question many traders ask is whether they should simply buy when the RSI drops below 30 or sell when the RSI is above 70. The answer would be no. If you're buying on a correction within a trend and the RSI falls into a desirable range, look for an entry point. That entry point would often be an area of support for uptrends and resistance for downtrends. You could also look for technical reversals that suggest the market has made a sharp turn.
This gives you three good rules for entering a trade:
- Follow the trend
- Enter on pullback
- Enter at a solid support or resistance level
Adjust Parameters to Suit Your Style
Some markets will enter into very strong trends at times without much of a correction. The RSI can stay at overbought or oversold levels for prolonged periods of time.
Don't blindly sell overbought markets. Too many traders have been burned making this mistake.
Most experienced traders will adjust the parameters on the RSI to meet their trading style. Some are short-term traders and they like a fast-moving RSI so they adjust the periods to a lower number like 4. You can also watch different levels for overbought and oversold.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.