Overbought or Oversold? Use the Relative Strength Index to Find Out

Cardwell considered bearish divergences as bull market phenomenon.

Resistance - The inverse of support, when the price is in an uptrend, sell-offs cause the price to reach a level and "correct" back to a price that isn't considered overbought. 

Failure Swings Wilder also considered failure swings as strong indications of an impending reversal.

Overbought and Oversold Levels 

Overbought vs Oversold Talking Points: Overbought means an extended price move to the upside; oversold to the downside. When price reaches these extreme levels, a reversal is possible. The Relative Strength Index (RSI) can be used to confirm a reversal.

A divergence signal forms when the RSI and stock prices move in opposite directions. When the stock or any financial instrument price is rising but the RSI oscillator is falling, it indicates that a reversion drop is impending. When a stock price is falling while RSI is rising, it indicates a reversion bounce is impending. As the stock makes new highs, RSI should also be making higher peaks. Divergence signals when the RSI starts to form lower high as the stock makes new highs.

The RSI is indicating the momentum is slowing down and an impending reversion sell-off is nearing. The stock peaked soon after RSI reached 70 and bottomed soon after the stock reached Divergences According to Wilder, divergences signal a potential reversal point because directional momentum does not confirm price. A bullish divergence occurs when the underlying security makes a lower low and RSI forms a higher low.

RSI does not confirm the lower low and this shows strengthening momentum. A bearish divergence forms when the security records a higher high and RSI forms a lower high. RSI does not confirm the new high and this shows weakening momentum.

The stock moved to new highs in September-October, but RSI formed lower highs for the bearish divergence. The subsequent breakdown in mid October confirmed weakening momentum. A bullish divergence formed in January-March. The bullish divergence formed with eBay moving to new lows in March and RSI holding above its prior low.

RSI reflected less downside momentum during the February-March decline. The mid-March breakout confirmed improving momentum. Divergences tend to be more robust when they form after an overbought or oversold reading. Before getting too excited about divergences as great trading signals, it must be noted that divergences are misleading in a strong trend.

A strong uptrend can show numerous bearish divergences before a top actually materializes. Conversely, bullish divergences can appear in a strong downtrend - and yet the downtrend continues. These bearish divergences may have warned of a short-term pullback, but there was clearly no major trend reversal.

Failure Swings Wilder also considered failure swings as strong indications of an impending reversal. Failure swings are independent of price action. In other words, failure swings focus solely on RSI for signals and ignore the concept of divergences. A bullish failure swing forms when RSI moves below 30 oversold , bounces above 30, pulls back, holds above 30 and then breaks its prior high.

It is basically a move to oversold levels and then a higher low above oversold levels. A bearish failure swing forms when RSI moves above 70, pulls back, bounces, fails to exceed 70 and then breaks its prior low.

It is basically a move to overbought levels and then a lower high below overbought levels. This also happens to be the name of the first chapter. Brown identifies a bull market range and a bear market for RSI.

RSI tends to fluctuate between 40 and 90 in a bull market uptrend with the zones acting as support. These ranges may vary depending on RSI parameters, strength of trend and volatility of the underlying security. RSI surged above 70 in late and then moved into its bull market range There was one overshoot below 40 in July , but RSI held the zone at least five times from January until October green arrows. In fact, notice that pullbacks to this zone provided low risk entry points to participate in the uptrend.

On the flip side, RSI tends to fluctuate between 10 and 60 in a bear market downtrend with the zone acting as resistance. RSI moved to 30 in March to signal the start of a bear range. The zone subsequently marked resistance until a breakout in December. Positive-Negative Reversals Andrew Cardwell developed positive and negative reversals for RSI, which are the opposite of bearish and bullish divergences.

Cardwell's books are out of print, but he does offer seminars detailing these methods. Before discussing the reversal technique, it should be noted that Cardwell's interpretation of divergences differs from Wilder. Generally, as the price of an asset rises, the RSI will rise as well, because average gains will outstrip average losses. Gains or losses don't continue indefinitely, though. And this is where the RSI can help in making trading decisions. Movements above 70 indicate overbought conditions.

The 50 level represents a neutral market In terms of market analysis and trading signals, RSI moving above the horizontal 30 reference level is viewed as a bullish indicator, while the RSI moving below the horizontal 70 reference level is seen to be a bearish indicator.

Since some assets are more volatile and move quicker than others, 80 and 20 are also frequently used overbought and oversold levels. As with other momentum oscillators, overbought and oversold readings for the RSI work best when prices are moving within a sideways range rather than trending up or down.

For example, if the trend is up, look to buy when the RSI crosses back above 30 from below. In a downtrend, look to sell or short when the RSI crosses back below 70 from above. In this way, trades are only taken in the trending direction, reducing the risk of potential false signals. A false signal occurs when the indicator gives a buy or sell signal after which the price doesn't follow through in the anticipated direction.

Momentum and the Relative Strength Index. The reasoning is that, in these instances, directional momentum does not confirm price. A bullish divergence forms when the underlying asset makes a lower low and RSI makes a higher low. RSI diverges from the bearish price action in that it shows strengthening momentum, indicating a potential upward reversal in price.

A bearish divergence forms when the underlying asset makes a higher high and RSI forms a lower high. RSI diverges from the bullish price action in that it shows weakening momentum, indicating a potential downward reversal in price. Divergence can last for a long time. Prices may continue to rise even though the RSI is showing a divergence.

 

Market News Headlines 

The most basic RSI application is to use the indicator to identify areas that are potentially overbought or oversold. Movements above 70 indicate overbought conditions. Conversely, movements under 30 reflect oversold conditions.

Working with RSI, I discovered a curious thing: RSI remains overbought or oversold in the strongest trends! Let’s look at a chart. In the chart above, RSI readings below 30 are colored red, while readings above 70 are colored green. Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. RSI oscillates between zero and Traditionally, and according to Wilder, RSI is considered overbought when above 70 and oversold when below  

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RSI Basics

RSI Is A Good Overbought Oversold Indicator Add RSI to EUR/USD daily chart and set it to 9. RSI default setting is 14, but we set it to 9 to have sharper highs and lows. The overbought region is considered to be over 70 - like GBP/USD at the time of writing this article: And the asset is in the oversold region when it dips below What does that mean? When an instrument's (a synonym for asset) price crosses the 70 or 30 mark of the RSI, then a reversal in its trend is highly likely.

Overbought vs Oversold Talking Points: Overbought means an extended price move to the upside; oversold to the downside. When price reaches these extreme levels, a reversal is possible. The Relative Strength Index (RSI) can be used to confirm a reversal. Overbought FX Pairs and Individual Currencies as of March 1, Data source: Bloomberg. Current FX Opportunities in Focus. US Dollar Immediately Stand Out on the Tails. A quick look above, and you can see that the 3-top oversold pairs (EUR/USD, AUD/USD, GBP/USD) per RSI(3) all show USD strength. On the opposite side of the .

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