A trade is profitable only when both buying and selling are done at the right time. Many a times, traders sell their positions too quickly and leave the profit on the table or they stay on the trade even after the trend changes. This causes the profits to evaporate and at times turn into business losses.
While it is important to trade with the trend, it is also important to keep an eye out for signs of reversal. If traders learn to recognize these warning signals, they can avoid buying tops and selling bottoms, 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 magnitude of recent price changes and as soon as it moves between 0 and 100. Generally, it is used to spot overbought and oversold levels on any given asset.
An asset is considered overbought when it exceeds its intrinsic value, either in the short term or long term, and this is an early sign that it may be vulnerable to a correction.
Similarly, an oversold reading shows that there has been a selloff and the asset is trading at a price below its intrinsic value. These assets are considered ready to rebound.
If the RSI trades between 50 and 100 it is believed to be in favor of the bulls. On the other hand, if the RSI is between 0 and 50, it indicates that the bears are in profit. A reading of 50 on the RSI is considered neutral, indicating a balance between bulls and bears.
The default setting on most charting software specifies readings above 70 as overbought and below 30 as oversold. However, if traders only use these prices as their guide for where to buy or sell, they can buy very early during a bear phase and sell in the early stages of a bull phase.
Therefore, it is important to understand how to use these overbought and oversold readings to maximize profits.
Let us look at some examples to understand the basics better.
As shown in the chart above, Binance Coin (bnb) broke its previous all-time high and started the next leg of its uptrend in February this year. The coin was at $52 when the RSI climbed above 70, indicating that it was overbought. Had traders sold at this point, they would have missed out on a substantial portion of future gains.
Remember, when a coin starts a new uptrend by breaking a range or important resistance levels, the RSI is more likely to stay in an overbought zone. This is because professional traders identify the start of a new uptrend and initiate buying without waiting for a dip to begin trading. Due to continuous buying, the RSI remains overbought for a long period of time. Therefore, in this example, the position should not be closed simply because it has moved above 70.
How to find overbought statuses
If the RSI rises above 85 in this opening period, it is time to be cautious. The BNB/USDT pair shows that the RSI climbed above 95 on February 19 when the price reached a local high of $348.70.
From there, the altcoin corrected 46% to $186.10 on February 23. During these phases of frenzied buying, a top is difficult to predict, so traders should tighten their stops to protect their profits when the RSI starts trading above 85.
On April 12, the RSI climbed above 85 again and reached the local top. This suggests that traders should be cautious when the RSI reaches 85 even during a strong bull phase.
Another thing to note is that from February to mid-May, the RSI never fell into the oversold zone. During a bull phase, the RSI usually takes support between 40 and 50. When the price falls between these levels, traders should be cautious and look for other supporting signals to initiate long positions.
As shown above, bitcoin (B T c) started its uptrend in October 2020. Notice how the RSI jumped up and remained above 70 during the first few days of the start of the bull run. However, the RSI did not reach the overbought zone above 85 during this period.
The RSI climbed above 85 in January and sell traders took over local tops during this period. As the price corrected, the RSI declined from the overbought zone to near the 40 level, giving traders a buying opportunity.
ether (ETH) also started its bull run in November 2020 but the RSI did not sustain in the overbought zone. The RSI jumped above the 85 level in early January itself and traders selling at this level would have been quick to book profits. This shows that there is no indicator or strategy that will work every time.
However, traders got two more buying opportunities when the RSI reached the 40 level. This would have given them an opportunity to re-enter the market and capture a substantial portion of the remaining bull run.
The RSI rose to 83.46 on May 11, slightly off the 85 mark and the biggest altcoin top on May 12. This suggests that the 85 level is not a magic figure and traders should be cautious when the price approaches it.
The RSI is a momentum oscillator, thus, when the price moves up, so should the RSI. However, sometimes the RSI diverges from the price action. In such situations, even when the price moves up, the RSI fails to do so.
This phenomenon is called negative or bearish divergence. This is a warning sign that the bullish momentum may be weakening.
The chart above is a good example of a downside divergence, which resulted in a steep drop. The RSI rose above 89 as bitcoin reached a new all-time high of $41,950 on January 8. However, the RSI continued to make lower highs as Bitcoin remained higher. This was a sign that the bullish momentum was waning.
When a downside divergence occurs, traders should be cautious and wait for the price to react to the downside before selling. In this case, a breakdown below the 50-day simple moving average or a break below the 45 level on the RSI was a sign that the trend may have run its course.
On February 19, the RSI climbed above 95 when BNB reached a new high of $348.70. From there, the price continued to rise, but the RSI formed lower tops forming a downside divergence.
This gave ample warning to traders that the bullish momentum is weakening and the altcoin is ready for a trend change. Traders could sell their positions when the RSI fell below the 45 level or when the price broke below the 20-day exponential moving average and then failed to rise above it on May 15.
polka dot (Telecom Deptt) is another good example where a negative divergence has resulted in a sharp drop. However, the RSI did not give a sell signal in this case. Therefore, it is important not to rely only on one indicator. A break below the moving average was a sign that the trend was turning and traders could sell there as the RSI was already indicating weakness in momentum.
Why Divergence Detection is Important
The RSI is an important indicator that can help signal the end of a bull phase. Both excessive readings and negative divergence in overbought territory can be used to book profits on positions prior to a trend shift.
Instead of trying to time the top, traders should consider selling when the RSI and moving averages indicate that the trend is losing momentum.
The views and opinions expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, so you should do your own research when making a decision.