The Relative Strength Index (RSI) is a classic technical indicator that is applied to identify the overbought and oversold states of the market.
While the RSI looks simple to use, there is one important element in it that many traders forget about: RSI is a lagging indicator.
It means that the indicator analyses the past price movements and not predicts the futures ones.
This default lag can sometimes mislead traders, especially when the markets are volatile or trade in a strong bullish/bearish trend.
In this article, we will discuss the situations when RSI indicator will lie to you. We will go through the instances when the indicator should not be relied on and not used, and I will explain to you the best strategy to apply RSI in strong trends.
Relative Strength Index analyses the price actions over a specific time period and displays a score between 0 and 100.
It is commonly believed that an RSI above 70 is an overbought condition, while an RSI below 30 is an oversold condition of the market.
By itself, the overbought and oversold conditions give poor signals, simply because the market may remain in these conditions for a substantial period of time.
Take a look at a price action on GBPCHF. After the indicator showed the oversold condition, the pair dropped 150 pips lower before the reversal initiated.
So as an extra confirmation, traders prefer to look for RSI divergence - the situation when the price action and indicator move in the opposite direction.
Above is the example of RSI divergence: Crude Oil formed a sequence of higher highs, while the indicator formed a higher high with a consequent lower high. That confirmed the overbought state of the market, and a bearish reversal followed.
However, only few knows that even a divergence will provide accurate signals only in some particular instances.
When you identified RSI divergence, make sure that it happened after a test of an important key level.
Historical structures increase the probability that the RSI divergence will accurately indicate the reversal.
Above is the example how RSI divergence gave a false signal on USDCAD.
However, the divergence that followed after a test of a key level, gave a strong bearish signal.
There are other, more profitable situations when RSI divergence can be applied, but we will discuss that later on, for now, the main conclusion is that
RSI Divergence beyond key levels most of the time will provide low accuracy signals.
But there is one specific scenario, when RSI divergence will give a particularly negative or unreliable signal.
In very rare situations, the market may trade in a strong bullish trend, in the uncharted territory, where there are no historical price levels.
In such cases, RSI bullish divergence will constantly lie, making retail traders short constantly and lose their money.
Here is what happens with Gold on a daily.
The market is trading in the uncharted territory, updated the All-Time Highs daily.
Even though there is a clear overbought state and a divergence,
the market keeps growing.
What traders do incorrectly, in a such a strong bullish market, they look for a bearish signal with RSI.
Only few knows, however, that even though RSI is considered to be a reversal, counter trend indicator, it can be applied for trend following trading as well.
On a daily time frame, after the price sets a new high, wait for a pullback to a key horizontal support.
Your bullish signal, will be a bearish divergence on an hourly time frame.
Here is how the price retested a support based on a previous ATH on Gold. After it approached a broken structure, we see a confirmed bearish divergence.
That gives a perfect trend-following signal to buy the market.
A strong bullish rally followed then.
RSI indicator is a very powerful tool, that many traders apply incorrectly.
When the market is trading in a strong trend, this indicator can be perfectly applied for following the trend, not going against that.
I hope that the cases that I described will help you not lose money, trading with Relative Strength Index.
