RSI will not offer you proper buying or selling signals in strong trending markets. Instead of using the indicator for entry signals, we can use it more as a filter to keep us out of trades that are less likely to work. Let me review what happens with the RSI in strong trends. Most traders are familiar with the Relative Strength Index or RSI. It is an oscillator that measures the strength of up or down moves in price relative to the stock’s previous price movements. The typical key levels for this indicator are 70 and 30. A value above 70% means that the stock is overbought and likely to drop soon. The RSI crossing below the 70% line is sometimes taken as a sell signal. Conversely, a reading below 30% shows the stock to be oversold and perhaps ready to rise. A buy signal is said to be generated when the RSI crosses above 30.
The problem with using the RSI in this manner is that in a strong uptrend the RSI will typically use 40 as a support level. When price is in a strong downtrend, the RSI will use 60 as a resistance level. When we are trading in the trend, we want to let our profits run as long as possible and do not want to enter into trades with a low probability of working. We use the RSI with 60 and 40 for the parameters to help us identify some of those opportunities as we approach supply and demand levels. If we just entered a supply zone and RSI is above 60 it would be prudent to pass on the short trade and if we just entered a demand zone we want the RSI to be above 40 to take a long trade.
The following charts show LULU entering a supply zone and a demand zone. Notice how the RSI is below 60 in the supply zone and above 40 in the demand zone and the trades worked.
In the following charts of LULU we have price entering a demand zone with RSI below 40 and price entering a supply zone with RSI above 60. As you can see these trades fail.
Even though we don’t trade using technical indicators we can use some indicators to help in our trading decisions. RSI is an important tool to help us qualify our trades. This filter has kept me out of many losing trades.