Relative Strength Index – Understanding Overbought and Oversold Readings

The Relative Strength Index just like any other momentum indicator defines overbought and oversold conditions. Signals gotten from Relative Strength Index indicator are quite reliable when the market is consolidating, asides that we should avoid using the indicator as a buy or sell indicator without integrating other analysis type on smaller time frames.

During trends, the RSI can be employed in determining overbought and oversold conditions. For situations like this, it is important that investors only trade in the direction of the trend.

Understanding Trend

It is important to understand the concept of trend; a trend is comprised of an “Uptrend” and “Downtrend”. An uptrend is a series of higher highs and higher lows. In a lot of cases we find trend lines being drawn through the lows. A downtrend on the other hand is a series of lower lows and maybe not always, a trend resistance line can be drawn across highs.

Reversal signal can be experienced at the end of a trend when we see a retracement from below the support line in a bullish trend or above the resistance line in a downtrend. For a complete confirmation of the reversal, we need to experience a break of the last major swing low in a bullish trend or that of the last swing high in a bearish trend would result in a confirmation of a bullish trend to be complete.

Let’s look at the chart below of the daily Euro-Dollar activity chart which clearly shows a strong and continuous bullish trend over the course of 6-months between the periods of 2006 – 2007. It should be noted how we get the major lows above the previous low in the trend and this was followed by higher highs in the entire scenario. This can be described as a major uptrend.

What can we conclude from the chart?

Looking at Fig. 1.0 you’ll notice a sideways trading range. We find both overbought and oversold alerts on this range as being valid. It is wise for us to note that a reversal signal should be considered when we get the same signal on the 4-hour and the hourly charts.

The major point that I should be stressing out here is the fact that the RSI readings are those of overbought and oversold conditions, but these does not define that price is actually overbought or oversold. For example, it is rather true when we these signals are accompanied by bearish divergence for an oversold condition; we then look at the overbought readings as basically saying that “the market is still buying.”

 

 

 

 

 

 

Fig. 1.0

A good understanding of a simple indicator like the Relative Strength Index alongside a firm knowledge of trend is a fine blend for success.