Only by buying and selling at the right time can the transaction be profitable. Many times, traders sell their positions prematurely and leave profits on the table, or they still insist on trading even after the trend changes. This causes profits to evaporate, and many times transactions turn into losses.
Although it is important to trade in line with the trend, it is also important to pay attention to signs of reversal. If traders learn to spot these warning signs, they can avoid buying at the top and selling at the bottom, which is a common experience for many new traders.
One tool that can help traders find trend reversals is the Relative Strength Index (RSI) indicator.
RSI is a momentum oscillator that measures the magnitude of recent price changes and the magnitude of its movement between 0 and 100. Generally, it is used to find the overbought and oversold levels of any asset.
When an asset exceeds its intrinsic value in the short or long term, it is considered overbought, which is an early sign that it may be susceptible to correction.
Similarly, oversold readings indicate excessive selling and the asset’s transaction price is lower than its intrinsic value. These assets are considered ready to rebound.
If the RSI is traded between 50 and 100, it is assumed that the RSI is favorable to the bulls. On the other hand, if the RSI is between 0 and 50, it indicates that bears have an advantage. An RSI reading of 50 is considered neutral, indicating a balance between bulls and bears.
The default settings of most charting software specify readings higher than 70 as overbought and lower than 30 as oversold. However, if traders only use these values as a buying and selling guide, they may buy prematurely in the bear market phase and sell in the initial phase of the bull market phase.
Therefore, it is important to understand how to use these overbought and oversold readings to maximize profits.
Let’s look at some examples to better grasp the basics.
As shown in the figure above, Binance Coin (Bitcoin) Broke the previous historical high and started the next segment of its upward trend in February this year. When the RSI rises above 70, the token price is $52, indicating that it is overbought. If traders sell at this time, they will miss a large part of their future earnings.
Please keep in mind that when the coin starts a new uptrend through a breakout range or key resistance level, there is a high probability that the RSI will remain in the overbought zone. This is because professional traders will find the beginning of a new uptrend and start buying without waiting to buy on dips. Due to continued buying, RSI remained overbought for a long time. Therefore, in this case, the position should not be closed just because it has risen above 70.
How to detect overbought conditions
If the RSI rises above 85 at this early stage, it is time to remain cautious. The BNB/USDT currency pair showed that the RSI rose above 95 on February 19, when the price hit a local high of US$348.70.
Since then, the altcoin has corrected 46% to $186.10 on February 23. In these stages of buying frenzy, it is difficult to predict the top, so when the RSI starts to trade above 85, traders should tighten their stop losses to protect their profits.
On April 12, the RSI once again rose above 85, making a local high. This shows that even in a strong bull market, when the RSI reaches 85, traders should remain vigilant.
Another point to note is that from February to mid-May, the RSI never fell into the oversold zone. During a bull market, RSI usually finds support between 40 and 50. When prices fall between these levels, traders should become cautious and look for other support signals to initiate long positions.
As shown in the figure above, Bitcoin (Bitcoin) The upward trend will begin in October 2020. Note how the RSI jumped and stayed above 70 in the first few days of the bull market. However, the RSI did not reach the extreme overbought area above 85 during this period.
The RSI rose above 85 in January, and traders who sold during this period hit the local high. With the price correction, the RSI fell from the overbought area to a level close to 40, which provided traders with a buying opportunity.
Ether (Ethereum) Also started a bull market in November 2020, but the RSI did not remain in the overbought zone. RSI only jumped above the 85 level in early January, and traders who sold at this stage could have made profits in advance. This shows that there is no indicator or strategy that works every time.
However, when the RSI reached the 40 level, traders got two more buying opportunities. This will give them a chance to re-enter the market and occupy a large part of the remaining bull market.
RSI rose to 83.46 on May 11, slightly below the 85 mark, and the largest altcoin peaked on May 12. This shows that the 85 level is not a magic number, and traders should exercise caution when the price is close.
RSI is a momentum oscillator, so when prices rise, RSI should also rise. However, sometimes the RSI deviates from price movements. In this case, even if the price rises, RSI will not do so.
This phenomenon is called negative divergence or bearish divergence. This is a warning sign that the bullish momentum may be waning.
The chart above is a good example of negative divergence, which caused a sharp decline. As Bitcoin rose to a record high of $41,950 on January 8, the RSI hit a high above 89. However, as Bitcoin continues to make higher highs, RSI continues to make lower highs. This is a sign that the bullish momentum is waning.
When a negative divergence is formed, traders should remain cautious and wait for the price to react downward before selling. In this case, a break below the 50-day simple moving average or a break below the 45 level of the RSI indicates that the trend may have ended.
On February 19, when BNB reached a record high of US$348.70, the RSI rose above 95. From there, the price continued to rise, but the RSI formed a lower top, forming a negative divergence.
This provides ample warning to traders that the bullish momentum is waning and that altcoins are ready for trend changes. When the RSI fell below the 45 level or the price fell below the 20-day exponential moving average, and then failed to rise above that level on May 15, traders could have sold their positions.
polka dot(point) Is another good example. Negative divergence leads to a sharp decline. However, in this case, RSI did not give a sell signal. Therefore, it is important not to rely on only one indicator. Breaking the moving average is a signal that the trend is changing, and since the RSI has indicated weak momentum, traders can sell there.
Why it’s important to find disagreements
RSI is an important indicator that can help indicate the end of the bull market phase. Both extreme readings and negative divergence in the overbought zone can be used to book a profit on a position before the trend changes.
When the RSI and moving average indicate that the trend is losing momentum, traders should consider selling instead of trying to determine the time of the top.
The views and opinions expressed here only represent the views of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading action involves risk, and you should conduct your own research when making a decision.