Trading Commodities with RSI and Momentum Indicators

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Momentum indicators are widely used by commodity traders to measure when a market is overbought or oversold. For traders who live by the old adage of buying low and selling high, momentum indicators are often a critical part of their trading arsenal.

Explaining the RSI

The RSI is one of the more popular momentum indicators and it is probably one of 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 they are days or 5-minute bars on a chart.

The main things you want to watch for are the readings above 70 or below 30. When the RSI is above 70, this means the market is overbought and likely due for a correction. When the RSI is below 30, this means the market is getting oversold and might be due for a rally. Of course, these numbers are to be used as a gauge to help in your buying and selling decisions and not as a trading system.

Trading with the RSI

Many trading books have been written on trading with momentum indicators and the RSI. There are more theories on trading with the RSI than anyone one person can discuss. Some methods are complete garbage, while many traders successfully use the RSI in their trading in their own unique ways. There are a couple of things you want to consider when using the RSI that will put you on the right path.

One of the best ways to use the RSI is to follow the trend and enter the market on pullbacks within a trend. The first thing to do is 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. In this case you would look for a buying opportunity when the market corrects and the RSI reaches and oversold level near 30.

This method is an easy way to identify buying opportunities in trending markets. The RSI will keep you from chasing a market when it is in an overbought condition. Your risk is much lower if you buy a bullish market when it is not in an overbought state. This trading method also helps a trader exercise patience and discipline. Many novice traders cannot 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 to that question would be no. If you are buying on a correction within a trend and the RSI falls into a desirable range, you should 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: following the trend, entering on pullback, entering at a solid support or resistance level.

Trading Tips on the RSI

A few words of caution need to be said about the RSI and momentum indicators.

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. Do not 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. I like to use the 3-period RSI on 5-minute and 15-minute charts for daytrading futures. I use 95 as the level for an overbought market and 5 as the period for oversold markets.