RSI is best used in swing trading to detect oversold and overbought conditions. Generally, when the RSI moves over 70, the market is considered overbought. When the RSI moves under 30 it is generally considered oversold. Traders use to buy at oversold levels, and sell at overbought levels.
Do you want to learn more about how you can use RSI in swing trading. Read on, and we will give you further guidance!
What Is Swing Trading?
Just as the name suggests, swing trading is a method of trading where traders attempt to make the most from the ‘swings’ in the financial markets. In this scenario, ‘Swings’ means the varying market price movements over periods of time. Swing Traders usually hold their positions for a few days, to a maximum of a few weeks.
To identify trading opportunities, swing traders largely use technical analysis and sometimes fundamental analysis. For technical analysis, traders normally use technical indicators that assist them in identifying the right entry and exit points.
The RSI or else known as the Relative Strength Index indicator is one the most commonly used technical indicator when it comes to swing trading.
What is RSI?
The Relative Strength Index (RSI) is a special indicator that helps financial markets traders to identify when the markets are oversold and overbought. It is normally categorized as a momentum indicator and evaluates the market by measuring the magnitude of price changes.
The indicator is normally displayed as an oscillator, which is a graph line that oscillates between two extremes of 0 and 100.
As you can see on the chart above, the RSI indicator is normally displayed below the trading chart as a line graph which in this case is red. In the middle of the RSI window, you can see how the middle area is highlighted in purple. The upper level is the overbought threshold, and the lower is the oversold threshold. In other words, every time the RSI lines crosses the upper threshold, it is an indication that the security is becoming overbought. Conversely, if the RSI line crosses below the lower threshold, that is an indication the security is becoming oversold.
What Are Oversold and Overbought Conditions?
To understand how to use the RSI indicator in swing trading, it is important to first understand what the oversold and overbought conditions are.
Just as in any market, the rule of supply and demand applies. Assets including financial assets operate on a supply-demand rule. If the supply is more than the demand, then the value of the asset is most likely to depreciate. If there is more demand than supply, then the value of the asset is most likely to appreciate.
In financial markets like equity indexes, there are times when the value of a financial instrument rises too much, often too quickly. In those times, the price is often referred to as overbought.
On the other hand, there are times when the value of the financial instrument falls too much, often too quickly. Investors and traders denote such conditions as oversold.
Below you see an image of a chart with RSI applied to it, where oversold and overbought levels are arrow marked.
In both cases, the markets often tend to react by a trend reversal to correct the prices. In the case of an overbought condition, the markets prices will make a downward reversal trend while in the oversold condition, the market prices will have an upward reversal trend. It is this tendency of some markets that are taken advantage of in mean reversion trading.
Using the RSI in Swing Trading
As we have gone through above, the RSI indicator is usually used in swing trading to detect when the market is about revert back to its mean. As we described above, an RSI value of more than 70 is often considered as overbought and an RSI value of less than 30 is generally considered oversold.
A Common RSI Strategy
One common strategy that is employed by traders is to buy a stock when the RSI is lower than 30, and sell when it gets higher than, for example, 50. The thresholds that signal buy and sell signals can be altered to fit with the market and timeframe you are playing with.
Generally, you would like to adjust the threshold values to maybe 80 and 40 in a rising market, and to 60 and 20 in a falling market. This is because that a rising market tends to move higher before it turns around, while the opposite is true for a falling market.
It is, however, worth noting that during very strong trends, the markets may take some time before making the corrective reversal movement. For instance, if there is a very strong bullish trend when an overbought condition is identified, then the market may take longer before a reversal pattern is initiated. In such cases, you might spot a divergence.
An RSI divergence is when the RSI line moves in the opposite direction of the price graph. For example, the RSI may have bottomed out at an oversold reading, and then start to rise slowly, while the market still continues downwards.
In that case, we have a bullish RSI divergence. Of course, there are bearish RSI divergences as well, which simply are inverted bullish RSI divergences. In other words, if the RSI line turns around from a high reading while the price of the security still makes new highs, we have a bearish divergence.
Divergences could be said to be a stronger indication of overbought or oversold conditions. The longer time a divergence persists, the more likely the market is to turn around. Of course, knowing exactly how long it will take before the market actually turns around is hard, but spotting divergences could be of tremendous help when combined with other indicators or price patterns.
The most common way of using RSI in swing trading is to spot oversold conditions. However, in some markets mean reversion does not work that well. In those markets, it might be better to use RSI as a measure of trend strength instead. For example, you could try to buy on a traditionally overbought RSI reading in hopes of catching a new trend.
Just keep in mind that trend and breakout strategies tend to have very few winning trades compared to mean reversion. This could make trend swing trading harder to manage psychologically!
Support and Resistance
RSI can also be used as support or resistance level. If you look at a chart and notice that there are certain RSI levels that the price turned around at or found hard to penetrate, you could anticipate price will find difficulties around those levels again.
If you want to find out more about support and resistance, we have a 4000-word article on that very topic!
Together With Other Indicators
RSI itself could work well in swing trading, but coupled with other trading indicators or price patterns, you could potentially get even better trading signals. There really is nothing that is right or wrong here. Experiment with different indicators like the ADX and MACD and see if you can come up with something that looks promising.
RSI is one of the most widely used trading indicators in swing trading. It works both for finding overbought and oversold conditions, as well as for defining breakouts that are worth following.
If you want more swing trading advice and tips, please have a look at our massive article on swing trading!