The RSI can be phenomenally powerful when applied appropriately for intraday trading. Unfortunately, so many people use it incorrectly, which leads themselves to incorrect decisions and ensuing losses.
If you find yourself consistently frustrated with RSI performance in your trading strategy, know that understanding its correct use may make the big difference.
Understanding the True Purpose of RSI
The RSI, as developed by J. Welles Wilder, is a momentum oscillator that measures the speed and magnitude of recent price movements to indicate overboughtness or oversoldness to determine potential points of reversal. However, using it based on traditional overbought/oversold levels to indicate buy or sell signals may be misleading.
The Myth of Overbought and Oversold
Most traders have an addiction to taking the RSI levels as absolute buy and sell signals. For example, if the RSI has just crossed above 70, their reaction is, “The asset is overbought; time to sell.” And the moment it falls below 30, they believe that the time to buy has arrived because it is over-sold.
This approach is flawed because terms like “overbought” and “oversold” may be misguiding in suggesting very strict sell or buy decisions, which are not justified in most of the situations.
Why is this wrong? Because RSI is a bounded indicator, with values bounded between 0 and 100, it contains an artificial ceiling and floor that cannot be penetrated. For this reason, the terms “overbought” and “oversold” are inapplicable in practicality. For example, if the RSI is above 70, that does not mean the stock is due for a fall-it may continue upwards if the momentum is still strong.
Correct Use of RSI
The RSI should be treated as a momentum indicator, rather than a mere overbought/oversold indicator. If the RSI is high-it is usually taken to be above 70-the reading indicates that the market has a strong upward trend with massive bullish momentum. This actually can be an indication for one to stay long and not to sell. On the contrary, if the RSI reading is below 30, that does not necessarily guarantee that the market will change its direction; it may indicate an upward movement with strong bearish momentum.
Key insight: a high RSI does not mean one should go short; it signals that dominant energy is on the bullish side. A low RSI does not automatically guarantee an indication to buy; it simply indicates strong bearish momentum.
Avoiding the Misconception of Divergence
Many traders enter into trades based on divergence. For example, if the price forms a higher high, but the RSI forms a lower high, that is looked upon by many as a bearish sign. While it may turn out successfully, sometimes it may also lead to failure.
The divergence may indicate a possible slackening in momentum, but this is not a guarantee of an immediate reversal. Price can still be making higher highs even if RSI is showing a slight divergence and result in losses if the trader reacts prematurely.
Why is this problematic?
Because the price action is what finally matters, not the divergence itself. You will enter the trade based on divergence alone, without taking into consideration the overall strength given by the RSI, and thus you will lose the trade.
Timing in RSI-Based Trading
Timing is everything when using RSI in intraday trading. You may pinpoint the dominant energy through RSI readings as bullish, but you could still lose a trade if you pick the wrong timing. It all comes down to timing your entry with price action and RSI momentum.
WD Gann’s Approach to Trading
The words of one of the world’s most famous traders, WD Gann, ring forth here: “When Time and Price come together, that and only that is the right time to buy.” In other words, knowing when to enter based on price and momentum means knowing the timing.
Free Timing Indicator
In further development of your RSI strategy, one should consider a timing indicator that will help in timing the perfect entry. Access the free 45-minute tutorial at indicatorwebinar.com and learn how to implement this indicator into your RSI to maximize your success as a trader. This can be implemented on TradingView, and any other popular trading platforms.
Putting It All Together
Trade with Momentum
Assess the strength of price action using RSI and trade in the direction of dominant market energy.
Ignore Overbought/Oversold Labels
Remember, the range of RSI is bounded, and a reading above 70 or below 30 does not necessarily constitute a reversal.
Understand Divergences
While divergences can be helpful, do not base entry or exit on them solely.
Combine Price and Time
Your entry should be in full agreement with the price trend and RSI reading for maximum probability of success.
Conclusion
RSI is a very powerful tool in intraday trading-but only for those who actually know how to use it. Understanding what the RSI is actually designed to do-a momentum indicator-and discarding some of the myths, will substantially improve your results. Begin with practicing the use of the RSI with a defined strategy and applying it jointly with other indicators in sharpening your decision-making skills.
