A trade is profitable only if both the purchase and the sale are done at the right time. Many times, traders sell their positions too early and leave profits on the table or they keep holding on to the trade even after the trend changes. This leads to profits evaporating, and many times the trade turns into a loss.
While it is important to trade with the trend, it is also important to keep an eye out for signs of a reversal. If traders learn to spot these warning signs, they can avoid buying at the tops and selling at the 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.
RSI basics
The RSI is a momentum oscillator that measures the magnitude of recent price changes and as it moves between 0 and 100. Generally, it is used to spot the overbought and oversold levels on any asset.
An asset is deemed to be overbought when it exceeds its intrinsic value, either in the short term or long term, and this is an early sign that it could be vulnerable to a correction.
Similarly, oversold readings suggest that the selling has been overdone and the asset is trading at a price below its intrinsic value. These assets are considered ready for a rebound.
The RSI is assumed to favor the bulls if it trades between 50 and 100. On the other hand, if the RSI is between 0 and 50, it signals that the bears have an advantage. A reading of 50 on the RSI is considered neutral, indicating a balance between the bulls and the bears.
The default setting on most charting software designates a reading above 70 as overbought and below 30 as oversold. However, if traders use only these values as their guide for buying or selling, they are likely to buy too early during a bear phase and sell in the initial stages of the bull phase.
Therefore, it is important to understand how to use these overbought and oversold readings to maximize profits.
Let’s see some examples to better grasp the basics.
As shown in the chart above, Binance Coin (BNB) broke above its previous all-time high and started the next leg of its uptrend in February of this year. The coin was at $52 when the RSI rose above 70, indicating it was overbought. Had the traders sold at this point, they would have missed a large part of the future gains.
Remember, when a coin starts a new uptrend by breaking out of a range or critical resistance levels, the possibility of the RSI remaining in the overbought territory is high. This is because professional traders identify the start of a new uptrend and start buying without waiting for a dip to purchase. Due to the sustained buying, the RSI remains overbought for a considerable duration.Therefore, in this instance, the position should not be closed just because it has risen above 70.
How to spot overbought conditions
If the RSI rises above 85 during this early period, it is time to be cautious. The BNB/USDT pair shows that the RSI rose above 95 on Feb. 19 when the price hit a local high at $348.70.
From there, the altcoin corrected 46% to $186.10 on Feb. 23. During these phases of frenzied buying, it is difficult to predict a top, hence traders should tighten their stops to protect their profits when the RSI starts to trade above 85.
On April 12, the RSI again rose above 85 and made a local top. This suggests, traders should be watchful when the RSI reaches 85 even during strong bull phases.
Another point to note is that from February to mid-May, the RSI never dipped into the oversold territory. During bull phases, the RSI generally takes support between 40 and 50. When the price dips between these levels, traders should become cautious and look for other supporting signals to initiate long positions.
As shown above, Bitcoin (BTC) started its uptrend in October 2020. Notice how the RSI jumped and remained above 70 in the first few days of the start of the bull run. However, the RSI did not reach the extremely overbought zone above 85 during this period.
The RSI rose above 85 in January and traders who sold during this period caught a local top. As the price corrected, the RSI dropped from the overbought territory to close to 40 level, which offered a buying opportunity to traders.
Ether (ETH) also started its bull run in November 2020 but the RSI did not sustain in the overbought territory. The RSI jumped above the 85 level only in early January and traders who sold at this stage would have been early in booking profits. This shows 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 large part of the remaining bull run.
The RSI rose to 83.46 on May 11, just shy of the 85 mark and the biggest altcoin topped out on May 12. This shows that the 85 level is no magical figure and traders should become cautious when the price nears it.
Bearish divergences
The RSI is a momentum oscillator, thus, when price rises, so should the RSI. However, at times the RSI diverges from the price action. In situations like these, 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 above chart is a good example of a negative divergence, which resulted in a massive fall. The RSI made a high above 89 as Bitcoin rose to a new all-time high at $41,950 on Jan. 8. However, as Bitcoin continued to make higher highs, the RSI continued to make lower highs. This was a sign that the bullish momentum was waning.
When a negative divergence forms, traders should become cautious and wait for the price to react downward before selling. In this case, the breakdown below the 50-day simple moving average or the break below the 45 level on the RSI was a sign that the trend may have run its course.
The RSI rose above 95 on Feb.19 when BNB reached a new all-time high at $348.70. From there, the price continued its up-move but the RSI made lower tops, forming a negative divergence.
This provided ample warning to traders that the bullish momentum was weakening and the altcoin was ready for a trend change. Traders could have sold their positions when the RSI dipped 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.
Polkadot (DOT) is another good example where the negative divergence resulted in a sharp fall. However, in this case, the RSI did not give a sell signal. Therefore, it is important to not rely on one indicator alone. A break below the moving averages was a signal that the trend was changing and traders could have sold there as the RSI was already signaling weakness in momentum.
Why spotting divergences is important
The RSI is an important indicator that can help signal the end of a bull phase. Extreme readings in the overbought territory and negative divergences both can be used to book profits on positions before the trend shifts.
Rather than trying to time the top, traders should consider selling when the RSI and moving averages signal 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, you should conduct your own research when making a decision.