Relative Strength Index
The RSI Indicator, being a momentum oscillator measures the velocity of directional price movements by calculating the ratio of higher closes to lower closes.
As I said some traders are convinced that a divergence between price and the indicator is a strong indication that a reversal will be coming soon.
I will, however, say this about the RSI Indicator and reverse divergences, I believe you can make money with reverse divergences, since the setups are with the trend. But, like other profitable setups, you've got to filter them down to tight low risk entries.
Here's an example:
On this next chart of NVLS, the Relative Strength Index breaks above 70 at around 11:30 am, comes back down to 45 and then back above 70. By doing this, the RSI indicator is telling you that on this time frame, price is now in an uptrend.
It's next low is lower than the previous low, while at the same time price has made a higher high - another reverse divergence.
On this next chart of XOM, the RSI Indicator makes two reverse divergences. Both would've made good trades, but remember, even though the relative strength index is showing trades with the trend and appears to work very well in this capacity, always use a low risk stop in case the trade goes wrong.
As mentioned, if you decide to trade divergences, trade reverse divergences, that way you'll be trading with the trend instead of fighting it.
Use well placed stops, and lets the winners run just like in my breakout strategies. And whatever you do, don't try to trade oversold/overbought signals from this indicator or any other indicator for that matter.
Alternate RSI Trading Method
The RSI Indicator can also be used as a trend indicator. The 70 and 30 lines can be used as trend boundaries. For instance, if price causes the indicator to register readings above 70, then a trader may consider price to be in an upward trend and to look for set-ups to buy. Vice versa for readings below 30.
Several consecutive reading between 70 and 30 would indicate a trendless or sideways period for price movement.
One method for triggering trades once the RSI has indicated a trend is to wait for a "hook" in the indicator. A hook is just a reversal of the indicator in the direction of the immediate trend.
Here's an example below on a 5 minute chart of Goodyear Co. (GT). GT, as indicated by the RSI Indicator is in a up trend around 10:30am. However, no trade trigger is initiated since RSI did not hook upward.
Price then causes RSI to go below 30, revealing a downward trend. At this point a trader would wait for a hook down to trigger a Short trade. One may only initiate trades from hooks between 30 and 70, or outside that boundary. That's up to the trader.
As you can see by the highlighted yellow area, RSI does a pretty good job of showing you when price is not trending. Price is causing the RSI to drift between 30 and 70.
There's a bevy of different ways to exit once in a trade. You could use the support & resistance, trendline or price target methods I've described or you could use the indicator for exits as well as entries. RSI trading exits could include, divergences or closes above/below 30/70 or even 50.
After you build up more and more screen time, the question you may eventually ask yourself is "Do I really need this indicator to tell me when a stock is in a trend and when it isn't?"
I'll venture to say that the answer is no, you won't. I know some price indicator traders will hate that I say this, but maybe just consider indicators as training wheels that can be taken off later on.
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