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 on to trading even if the trend reverses. 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 watch out for signs of reversal. By learning to recognize these red flags, traders can avoid buying up and selling down, which is a common experience for many new traders.
One tool that can help traders spot trend reversals is the Relative Strength Index (RSI).
Basic knowledge of RSI
RSI is a momentum oscillator that measures the next price change and moves between 0 and 100. It is generally used to identify overbought and oversold levels on any asset.
An asset is considered overbought if it exceeds its intrinsic value in the short or long term, and this is an early sign that it could be corrected.
Similarly, an oversold zone indicates that the sale has been oversold and the asset is trading at a price below its intrinsic value. These assets are deemed to be ready for restoration.
The RSI is taken in favor of the bulls when it trades between 50 and 100. On the other hand, if the RSI is between 0 and 50, it signals that the bears have the upper hand. The level of 50 in the RSI is considered neutral and shows an equilibrium between the bulls and the bears.
The default setting for most charting software indicates values above 70 as overbought and below 30 as oversold. However, if traders use these values only as a guide to buy or sell, they are likely buying too early in the decline and selling in the early stages of the bull run.
Hence, it is important to understand how to use these overbought and oversold indicators to maximize profits.
Let’s look at some examples to better understand the basics.
BNB / USDT daily chart | Source: TradingView
As the graph above shows, Binance Coin (BNB) broke its all-time high and started the next phase of its upward trend in February of this year. Altcoin is at $ 52 as the RSI rises above 70, suggesting it is overbought. If traders sell at this point, they are missing out on a large portion of future profits.
Remember, if a coin begins a new uptrend by crossing a range or major resistance levels, the chances are very high that 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 the price to decline. Persistent buying keeps the RSI overbought for a long time, so in this case it is not advisable to close the position just because it has risen above 70.
How to spot overbought terms
BNB / USDT daily chart | Source: TradingView
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. During these frenzied buying periods, highs are difficult to predict, so traders should tighten their stops to protect your profits when 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 careful when the RSI hits 85, even during times of sharp price increases.
Another point to note is that the RSI never drops into the oversold zone from February to mid-May. During bullish periods, the RSI usually receives support between 40 and 50. If the price falls between these levels, traders should be cautious and look for other support signals to initiate long positions.
BTC / USDT daily chart | Source: TradingView
As shown above, Bitcoin (BTC) started an upward trend in October 2020. Notice how the RSI shot up and stayed above 70 in the first few days of the start of the bull cycle. However, the RSI failed to hit the extremely overbought zone above 85 during this period.
The RSI surged above 85 in January and traders selling during that period hit the local top. As the price corrects, the RSI falls from the overbought zone to the 40 level, offering traders a buying opportunity.
ETH / USDT daily chart | Source: TradingView
Ether (ETH) also started a rally in November 2020, but the RSI failed to stay in the overbought zone. The RSI only rose above 85 in early January and traders sell at this stage was locked. This shows that no indicator or strategy is always right.
However, traders have two more buying opportunities when the RSI hits 40. This gives them the opportunity to get into the market and take advantage of much of the remaining rally.
The RSI rose to 83.46 on May 11, just below the 85 mark, and the largest altcoin peaked on May 12.
Negative divergence
The RSI is a momentum oscillator, so when the price goes up, the RSI goes up too. However, sometimes the RSI is different from the price action. In situations like this, the RSI still falls even as prices rise.
This phenomenon is known as negative divergence. This is a warning sign that bullish momentum may be weakening.
BTC / USDT daily chart | Source: TradingView
The graph above is a good example of a negative divergence leading to a large drop. The RSI hit a high of over 89 as Bitcoin rose to a new all-time high of $ 41,950 on Jan. 8. However, as Bitcoin continued to peak, the RSI continued to hit lower highs. This is a sign that the bullish momentum is weakening.
When a negative divergence forms, traders should be careful and wait for the price to drop before selling. In this case, traders may need to ask to sell if the price drops below the 20-day EMA. A break below the 50-day SAM line or break below the 45-day RSI is a sign that the trend may have been on the right track.
BNB / USDT daily chart | Source: TradingView
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 rise, but the RSI made lower highs and formed a negative divergence.
This has warned traders that bullish momentum is weakening and the altcoin is ready for a trend change. Traders may have sold their positions when the RSI fell below 45 or when the price fell below the 20-day EMA.
DOT / USDT daily chart | Source: TradingView
Polkadot (DOT) is another good example where negative divergence leads to a large drop. In this case, however, the RSI does not give a sell signal. Hence, we shouldn’t rely on an index. A break below the moving averages is also a signal that the trend is changing and traders may have sold there as the RSI has signaled a weakening of momentum.
Why is it important to recognize deviations?
The RSI is an important indicator that can signal the end of an upward phase. Both overbought extremes and negative divergence can be used to take profits 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.
Disclaimer: This article is for informational purposes only, not investment advice. Investors should research carefully before making a decision. We are not responsible for your investment decisions.
SN_Nour
According to Cointelegraph
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