This page expands on the explanation of RSI overbought and oversold levels. It will discuss possible improvements of an overbought/oversold RSI trading strategy.
Overbought / Oversold RSI Strategies
RSI (Relative Strength Index) is one of the most popular indicators. The most common way to trade with it is by looking at overbought and oversold areas. You buy when RSI says oversold and you sell when it says overbought. This approach is trading against the market trend and therefore it is possible that you will be wrong often. There are adjustments you can make to the raw overbought/oversold RSI trading strategy to have the number of situations when you bet against the market and lose reduced (if you do this right and are lucky).
Two Common Ways to Improve RSI Winning Percentage
As with many other indicators and trading strategies you can do this by waiting for a confirmation before entering a trade. With RSI overbought and oversold levels there are two typical ways how to get a confirmation that the market is likely to go in your direction:
- Wait until RSI reverses.
- Wait until RSI leaves the oversold or overbought area and returns to the neutral area.
Example: Waiting until RSI Reverses
Let's say you trade with RSI and your oversold and overbought thresholds are 20 and 80. When the RSI shows an oversold market (e.g. it has fallen to 5) and you are thinking about going long, you don't buy immediately, but wait for confirmation.
Then RSI reverses and rises from 5 to 12. It tells you that the market might not be so bearish any more – the bears have definitely lost some power on this last bar. We don't know if it is just a small correction or a reversal, but you never know this until the next bars and then it's too late. So when the RSI fails to make a new low and instead rises from 5 to 12 you consider it a sign of a possible reversal and buy. This is an example of the first one of the bullet points above (wait until RSI reverses).
Example: Waiting until RSI Returns to the Neutral Area
The second strategy is even more conservative. When RSI rises from 5 to 12, you see that it is still below the oversold borderline and therefore still consider it too dangerous to bet against the (still heavily bearish) market mood.
Then on the next bar the RSI rises from 12 to 22, leaves the oversold area and returns to the neutral area (between 20 and 80). This is the sign that the bearish momentum has faded and you buy the market.
Is Waiting for Confirmation Worth It?
By waiting for confirmation you filter out some situations when the market merely makes a small correction and then continues in the original trend (which you intended to bet against). Of course there will still be situations when RSI comes back to the neutral area, only to return to oversold on the next bar and you lose anyway. But in the long run you can improve your winning percentage in this way. The cost is that you usually give up a piece of potential profit, as you are entering after the market has gone a bit in your direction already. Is it worth it? Sometimes – that is up to your research and your own trading to figure out.