When assets enter a bear market phase and the headlines are negative, analysts are expected to fall further, changing sentiment from optimism to pure pessimism and doom. This causes panic traders to sell positions rather than buy near the bottom of the downtrend.
How do traders go against the trend and muster the courage to buy in a bear market? This is not easy, because if they buy too early, the position may quickly become a loss. However, if they wait too long, they may miss the early stages of the rally.
Although it is difficult to pull the trigger during a bear market, the Relative Strength Index (RSI) indicator can identify market bottoms and favorable risk-reward scenarios.
Let’s review a few examples of when to buy in a bear market.
Look for extremely oversold levels on RSI
Bitcoin (Bitcoin) Reached a peak of close to USD 20,000 in December 2017 and started a long and painful bear market, which bottomed out in December 2018 and rebounded to around USD 3,300. During this period, RSI has entered the oversold zone five times (reading below 30) (marked as an ellipse on the chart).
In the first four times, the RSI was close to or slightly below the 30 level, but in the fifth time, the RSI fell to 10.50. This is a sign of surrender. In this case, traders who have been grabbing the bottom or holding positions in a bear market succumbed to fear and cleared their holdings.
Usually, a long-term bear market ends after a long period of fear-based selling. Smart traders will wait for these opportunities and buy when the market is severely oversold, such as when the RSI is below 20.
Fast forward to 2019 and 2020, when the RSI was close to 20 twice and fell to 15.04 on March 12, 2020.
The first trading result of the currency pair falling to 19.60 on September 26, 2019 proved to be a loss-making transaction, as the price hit a new local low on October 23, 2019 a few weeks later. This indicates that traders should be prepared to close positions when the stop loss is touched and establish positions in time, because if they do not, losses may continue to grow.
On November 24, 2019, the RSI fell to 22.32, slightly above the 20 level. For traders who maintain a very tight stop loss, this may also be a loss-making trade that fell on December 18, 2019. However, these are small losses and will not have an impact on the investment portfolio unless the trader uses heavy leverage.
RSI plummeted to 15.04 on March 12, 2020. If traders are willing to buy after this decline, they will get huge gains from holding positions in the bull market. The bull market reached its highest point of $64,854 on April 14, 2021. . It shows how the trader finally used the RSI signal to win the prize after two failed purchases.
Combining RSI with a moving average will produce a better signal
In the ether (Ethereum) During the bear market in 2018, the RSI broke below or was close to the 20 level four times. The first opportunity provides traders with strong returns, but the other two opportunities are losers.
In order to avoid washing, traders may add additional filters to prevent them from losing trades. A simple example might be that instead of buying immediately after the RSI drops below 20, a trader waits for the price to close above the 20-day exponential moving average for three consecutive days before buying.
As shown in the figure above, the buy signal in April 2018 was triggered when the ETH/USDT currency pair fell below the 20 level of the RSI and rose above the 20-day moving average. Due to the sharp rise in the currency pair, this transaction proved to be profitable.
The next buy signal in August did not meet the criteria because the price did not rise above the 20-day moving average for three consecutive days. The third transaction in September will turn into a small loss, but the November transaction will make a huge profit.
Bullish divergence and how to spot them
Another important tool that can help warn traders of a possible trend reversal is bullish divergence. This happens when the price continues to fall but the RSI makes a higher low, indicating that the bearish momentum may be waning.
Litecoin (LTC) Shows two bullish divergences formed during the 2018 bear market phase. The first divergence formed from August to September 2018 proved to be a false signal because the price did not rise above the swing high.
However, the second bullish divergence from November to December 2018 became a profitable signal at the bottom and then rose sharply in the following days.
Another slightly longer example of bullish divergence can be seen in Ethereum Classic (and many more) September to December 2019. During this period, prices made lower lows, but RSI formed higher lows. The ETC/USDT pair surged within a few days after breaking the swing high.
VeChain (veterinary) Also shows the formation of a bullish divergence from September 2020 to October 2020, followed by a huge bull market. This shows that bullish divergence is a useful tool, which can greatly benefit traders if used wisely.
Some important gains
The bear market offers the opportunity to buy assets at a steep discount, but when everyone is selling and emotionally negative, buying assets is not easy.
However, traders who use RSI can take advantage. Extremely oversold RSI is a sign of surrender, which usually marks the end of the bear market phase. This strategy can help traders pull the trigger when it’s important.
Sometimes, RSI may give false signals, so traders can use additional filters, such as daily closing prices higher than the 20-day and 50-day moving averages, to avoid washing trades. Finding a bullish divergence can also alert traders that a downtrend may be coming to an end.
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.