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The Relative Strength Index, or RSI, was created by Welles Wilder, and its main purpose is to identify extreme conditions in the market. By showing if the market is in oversold or overbought territory, we can make better trading decisions.
The RSI is an oscillator that is scaled from 0 to 100, with readings below 30 indicating oversold, while readings over 70 indicate overbought territory.
The RSI can be used to identify extremes, to confirm a trend and also to identify divergence. We will look at each of these principles in detail.
If the RSI is below 30, this is the oversold territory. Selling pressure is high and a technical correction is likely. Prices are forming a bottom since there are no more sellers and therefore buyers begin to come into the market. Prices eventually head back up.
If the RSI indicator turns up as well, then this is a good opportunity to buy.
Remember that just because the RSI falls below 30, it does not mean it is a signal for immediate buying because the RSI may stay in the oversold territory for a long time. In order to enter at the right moment (on true market reversal) you should wait for the RSI to leave the oversold territory.
Look at the chart below. When the RSI goes below 30, you would be on the lookout for an opportunity to buy, however your actual trade will take place only when the RSI crosses up above 30.
Overbought TerritoryIf the RSI is above 70, this is overbought territory. Buying pressure is high, and prices will form a top. Fewer buyers remain in the market and sellers begin to come in. A correction is likely, turning prices back down. If the RSI turns down as well, this is a good opportunity to sell.
Note Before Trading:Once the RSI goes above 70, you should wait for the indicator to come out of the overbought area and cross below 70 before placing your sell order. Look at the chart below.Bullish divergence occurs when the market is in a downtrend and prices are making a new low but the RSI does not continue lower and instead begins to climb back up. This is a bullish signal indicating that the trend is about to change direction to an uptrend. This gives us the opportunity to buy.
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