A trade is only profitable if both the buy and the sell are made at the right time. Often times, traders sell their positions too early and leave profits on the table, or they hold the trade even after trend changes. This causes profits to fizzle out and the trade often turns into a loss.
While it is important to trade with the trend, it is also important to be on the lookout for signs of a turnaround. By learning to recognize these red flags, traders can avoid buying the highs and selling the lows, which is a common experience for many new traders.
One tool that can help traders spot trend reversals is the Relative Strength Index (RSI) indicator.
The RSI is a momentum oscillator that measures the extent of recent price changes and moves between 0 and 100. Generally it is used to identify the overbought and oversold levels on any asset.
An asset is considered overbought if it exceeds its intrinsic value in the short or long term. This is an early sign that it could be prone to correction.
Similarly, oversold readings suggest that the sale has been overdone and the asset is trading at a price below its intrinsic value. These assets are considered ready for recovery.
The RSI is believed to favor the bulls when trading between 50 and 100. Conversely, when the RSI is between 0 and 50, it signals that the bears have an advantage. A value of 50 on the RSI is considered neutral, which indicates an equilibrium between bulls and bears.
The default setting of most charting software indicates a value above 70 as overbought and below 30 as oversold. However, if traders only use these values as a guide to buying or selling, they are likely buying too early in a bear phase and selling in the initial phase of the bull market.
Hence, it is important to understand how to use these overbought and oversold assets to maximize profits.
Let’s look at some examples to better understand the basics.
As the graph above shows, Binance Coin (BNB) broke its all-time high and started the next stage of its upward trend in February of this year. The coin was at $ 52 when the RSI surged above 70, suggesting it was overbought. Had traders sold at this point, they would have missed out on much of future profits.
Remember, if a coin begins a new uptrend by breaking out of a range or critical resistance levels, there is a good chance the RSI will remain in the overbought territory. This is because professional traders recognize the beginning of a new uptrend and start buying without waiting for a decline to buy. Because of the continued buying, the RSI remains overbought for a considerable length of time. Therefore, in this case, the position should not be closed just because it has risen above 70.
How to spot overbought terms
If the RSI rises above 85 at this early stage, it is time to be careful. The BNB / USDT pair shows the RSI rose above 95 on February 19 as the price hit a local high at $ 348.70.
From there, the altcoin corrected 46% to $ 186.10 on February 23. It is difficult to predict a high during these periods of frenzied buying urgency, so traders should tighten their stops to protect their profits if the RSI begins to trade above 85.
On April 12th, the RSI rose again above 85 and hit a local high. This suggests that traders should be vigilant if the RSI hits 85 even in strong bulls.
Another point to note is that the RSI never plunged into the oversold territory from February to mid-May. During bull phases, the RSI generally takes between 40 and 50 support. If the price falls between these levels, traders should exercise caution and look for other supportive signals to enter long positions.
As shown above, Bitcoin (BTC) started its uptrend in October 2020. Notice how the RSI jumped and stayed above 70 in the first few days after the bull run began. However, the RSI did not reach the extremely overbought zone above 85 during this period.
The RSI rose above 85 in January and traders selling during that period made a local high. As the price corrected, the RSI fell from the overbought area to close to 40, offering traders a buying opportunity.
Ether (ETH) also started its bull run in November 2020, but the RSI failed to stay in the overbought territory. The RSI only jumped above the 85 mark in early January and traders who were selling at the time would have made early gains. This shows that there is no indicator or strategy that works every time.
However, traders were given two more buying opportunities when the RSI hit the 40 level. This would have given them the opportunity to get back into the market and capture much of the remaining bull run.
The RSI rose to 83.46 on May 11, just 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 be careful as the price approaches.
The RSI is a momentum oscillator, so if the price goes up, the RSI should rise. However, sometimes the RSI will deviate from the price movement. In situations like this, even if the price goes up, the RSI does not.
This phenomenon is known as negative or bearish divergence. This is a warning sign that bullish momentum may be weakening.
The graph above is a good example of a negative divergence that resulted in a massive decline. The RSI hit a high of over 89 as Bitcoin rose to a new all-time high of $ 41,950 on Jan. 8. However, while Bitcoin continued to hit higher highs, the RSI continued to hit lower highs. This was a sign that the bullish momentum was weakening.
When a negative divergence forms, traders should exercise caution and wait for the price to react down before selling. In this case, the break below the 50-day simple moving average or break below the 45-mark of the RSI was a sign that the trend may have started.
The RSI rose above 95 on February 19 as the BNB hit a new all-time high of $ 348.70. From then on, the price continued to move higher, but the RSI made lower highs and formed a negative divergence.
This broadly warned traders that bullish momentum was weakening and the altcoin was ready for a turnaround. Traders could have sold their positions when the RSI fell below the 45 mark or when the price fell below the 20-day exponential moving average and then didn’t move above it on May 15.
Polkadot (DOT) is another good example where the negative divergence resulted in a sharp decline. In this case, however, the RSI did not send a sell signal. Therefore, it is important not to rely on just one indicator. A break below the moving averages was a signal that the trend was changing and traders there could have sold as the RSI was already signaling weakness in momentum.
Why it is important to recognize divergences
The RSI is an important indicator that can signal the end of a bull phase. Extreme values in the overbought area and negative divergences can be used to book profits from positions before the trend changes.
Rather than trying to time the top, traders should consider selling if the RSI and moving averages are signaling that the trend is losing momentum.
The views and opinions expressed are those of the author only and do not necessarily reflect the views of Cointelegraph.com. Every step of investing and trading involves risk, so you should do your own research when making a decision.