Written by Brandon Wendell, Online Trading Academy
Online Trading Academy Article of the Week
In my earlier article, “Relative to the Trend,” we discussed the use of the Relative Strength Indicator (RSI) as a way to help identify the trend and potential reversals of those trends. I mentioned that most traders and investors improperly use the RSI to receive buy or sell signals. Instead of using the indicator for entry signals, I use it more as a filter to keep me out of trades that are less likely to work.
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The previous article specified the new parameters that should be used with the RSI. 60 is the new overbought and 40 is the new oversold reading. We use the RSI with those new parameters to help us determine whether we should enter a position or wait as price approaches supply and demand levels.
The RSI measures momentum in price movement. When we are moving in an uptrend, you would expect the momentum to be bullish and not become oversold at any time if the trend is to continue. An oversold reading means the bears have grown stronger and may reverse the price trend or not allow price to move upwards freely.
In an uptrend, we want to hold long positions as supply breaks and prices move to higher levels. If we see on pullbacks that the price fails to break 40 on the RSI, then you are still in a bullish trend and are likely to break the subsequent supply level.
In the following chart of SPY, when prices return to the demand zone the RSI is above 40. This suggests that the bullish trend is still intact. The location of the RSI above 40 confirms that there is still a lot of bullish pressure and that demand is likely to produce a significant price move upward and exceed the prior high.
However, if you are looking to buy during a pullback to demand and the RSI is below 40, you may want to pass on the trade or have a closer target since price is less likely to make new highs when/if it bounces.
In a downtrend, we want to let our shorts go as far as possible to maximize profits. Prices should not become overbought on the RSI while in a downtrend. Strong bullish pressure signals the downtrend is not as powerful as it was.
When we see rallies in the bearish trend fail to breach the 60 level on the RSI, then the bearish momentum and downtrend is still strong and we are likely to see prices continue to break demand levels.
If we see the RSI moving above 60 when price hits supply, we may want to look for another trade or have shorter targets as price is unlikely to make new lows if it does bounce from supply.
To remember the use of the RSI, I have come up with a saying: “If at demand and the RSI is less than 40, then demand will not stand. And if at supply and the RSI is above 60, then supply is a lie.
Remember that RSI, as with any technical indicator, is to be used as an odds enhancer. Educated traders know that the decision to buy or sell should be made from the price action itself and the use of the core strategy of Supply and Demand. For more about this, see the video below.
Author’s note: To learn this valuable skill (identifying supply and demand), visit your local Online Trading Academy center today!
