How to trade using RSI: A closer look at the most popular RSI-based stock trading strategies

ByPavel Fedorov

Relative Strength Index (RSI) is a popular technical indicator used by traders to measure the strength of a security’s price action. RSI compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.

Overbought/oversold strategy

One of the most popular stock trading strategies that uses the RSI indicator is the RSI overbought/oversold strategy. This strategy is based on the idea that prices will tend to revert to their mean levels over time. When the RSI of a stock is above 70, it is considered to be overbought, and when it is below 30, it is considered to be oversold. A trader can use this information to buy when the RSI is oversold and sell when it is overbought.

Pros:

  • One of the main benefits of this strategy is its simplicity. It is easy to understand and implement, even for traders with limited experience.
  • It is a strategy that can be used in a variety of market conditions.
  • The RSI overbought/oversold strategy can be used to identify potential buying and selling opportunities when a stock has reached overbought or oversold levels, providing a clear signal for traders to enter or exit a trade.

Cons:

  • The strategy is based on the assumption that prices will revert to their mean levels over time, but this is not always the case.
  • This strategy only takes into account RSI readings, ignoring other market factors. It’s important to take into account other technical indicators and fundamental analysis to have a clear understanding of the market conditions.
  • Another disadvantage of this strategy is that it is based on fixed RSI levels (70 and 30). However, these levels may not be appropriate for all stocks, as each stock may have its own unique characteristics.

The RSI divergence strategy

Another popular strategy that uses the RSI indicator is the RSI divergence strategy. This strategy is based on the idea that when the RSI is diverging from the price action, it can be an indication of a potential trend reversal. For example, if the stock price is making new highs while the RSI is failing to confirm, it could be a bearish signal. Similarly, if the stock price is making new lows while the RSI is failing to confirm, it could be a bullish signal.

Pros:

  • The RSI divergence strategy is based on a clear and well-established principle, namely the idea that divergences can indicate trend reversals.
  • It is a strategy that can be used in any market, for any stock.
  • By identifying potential divergences early, traders can enter or exit trades before the rest of the market catches on, potentially capturing more profit.

Cons:

  • One of the main disadvantages of this strategy is that it can be difficult to spot divergences, particularly for traders with limited experience.
  • Divergences are not always reliable, and they may not always lead to trend reversals. Traders need to be careful when interpreting these signals.
  • Divergence signals can be delayed, so traders need to be patient and wait for the price to confirm the signal.

RSI-based trend-following strategy

A third strategy that uses the RSI indicator is the RSI-based trend-following strategy. This strategy is based on the idea that the RSI can be used to determine the direction of the trend. A trader can use the RSI to identify bullish trends when the RSI is above 50 and bearish trends when the RSI is below 50. Once the trend has been identified, the trader can then use the RSI to enter trades in the direction of the trend.

Pros:

  • This strategy is simple and easy to understand, and it can be used by traders of all experience levels.
  • It provides a clear signal for entering or exiting trades based on the direction of the trend.
  • Traders can use this strategy to take advantage of market trends that last for a longer period of time.

Cons:

  • Like any other trend-following strategy, RSI-based trend-following strategy is based on the assumption that trends will continue, but this is not always the case. Trends can change or reverse without warning.
  • If the trend changes, traders using this strategy may be caught in a losing position.
  • The strategy also depends on RSI indicator and its 50 level, but it doesn’t consider any other market factors, which might give a more comprehensive understanding of the market conditions.

RSI swing trading

A fourth strategy is RSI swing trading, This strategy is based on identifying swing points on the chart that are likely to be the beginning of a trend. A swing point occurs when the RSI has reached overbought or oversold levels and then begins to retreat. By identifying these swing points, a trader can enter trades in the direction of the trend, with the goal of riding the trend for as long as possible.

Pros:

  • This strategy allows traders to enter trades early in a new trend, potentially capturing more profit.
  • It’s quite simple to understand and implement and can be useful in identifying short-term trends.
  • It can be used in conjunction with other technical indicators to confirm trade signals.

Cons:

  • As the strategy is focused on short-term trends, traders are more exposed to market noise and volatility.
  • Swing trading requires a high level of discipline and focus. If a trader is not careful, they may enter trades too early or exit them too late.
  • It’s a strategy that could be affected by market news, unexpected events or fundamental analysis, and that might cause a change in the trend.

RSI based Moving Average Crossover

Finally, RSI based Moving Average Crossover is another strategy that use RSI. This strategy uses two moving averages of RSI; a short-term moving average and a long-term moving average. This strategy generates buy and sell signals when the short-term moving average crosses above the long-term moving average, and vice versa. This strategy can be useful in identifying changes in momentum and trend, which can be helpful in making buy and sell decisions.

Pros:

  • Moving Average Crossover strategy is a simple and easy to understand strategy that is widely used by traders.
  • This strategy can be useful in identifying changes in momentum and trend, which can be helpful in making buy and sell decisions.
  • It can also be used to identify potential overbought and oversold conditions, providing clear signals to enter or exit trades.

Cons:

  • This strategy is lagging, and it may generate signals that are not timely, which could lead to missed opportunities or poor trade entries.
  • As with any other moving average strategy, it’s important to consider that moving averages are lagging indicators, and they may not always provide accurate signals.
  • Like any other strategy, it’s important to combine it with other indicators and market analysis to have a clearer picture of the market conditions before making any trade decision.

Overall, RSI is a versatile indicator that can be used in a variety of ways to help traders identify potential trading opportunities. Whether you are a short-term trader looking for quick profits or a longer-term investor looking to build a portfolio, the RSI can be an valuable tool to help you make better trading decisions. However, it’s important to keep in mind that these strategies are not one-size-fits-all, past performance is not a guarantee of future results and it’s important to always consider your risk management before executing any strategy.