J. Welles Wilder developed the tool that he called the Relative Strength Index or RSI.
The purpose of his tool is to try to determine the relative strength of the market at any given time. Using this tool can help you identify how powerful the various moves in the market are, and if the prevailing trend seems to hold up as it moves along.
In other words, is the movement that you see in the market right now legitimate or is it simply a fake-out that you can ignore?
How To Read The Relative Strength Index (RSI) Indicator
The RSI has a lot of similarities to the Stochastic in that it is easy to read, and you are simply looking for the indicator to cross above or below certain key numbers.
The RSI ranges from 0 to 100, but you are looking for times when it crosses above 70 or below 30 to get an idea of what is happening in the market.
When the RSI crosses above 70, it is indicating that the market may be overbought, and it might be time to sell, or at least not to buy more at this stage of the game.
When the RSI closes below 30, it is indicative of a market that is oversold, and it might be time to place a buy order, or at least to unwind your sell position.
You should also note that an RSI that crosses below the 50 mark headed down is indicative of a bearish move until it reaches the 30 mark. When the RSI crosses above the 50 mark and is headed upward, it is a bullish indicator until it reaches the 70 mark.
Those are the kind of movements to look for as you try to interpret the data that this indicator produces.
Confirming Trend Formations
Instead of using the RSI solely for the purpose of determining when a trend is ending, you ought to try to use it to confirm a trend that you believe you see forming.
When you are trying to capitalize on a trend that you believe you have spotted forming, you should look at the RSI to see if it agrees with your assessment. If that is the case, then you can hop on the train and profit along the way. However, if the RSI is not in agreement with your assumptions, then you may want to hold back until a new opportunity occurs.
The RSI is great to use as another layer of confirmation before you make a trade.
It is not recommended that you rely solely on this or any indicator as your only point of reference for making a trade. Obviously, putting too much at stake on a single indicator is likely to prove to be unwise.
Instead, you should use this as a way to back up your assumptions about certain trends, and then move on from there. If you do that, then you should be in a good position to trade more accurately with the market going forward.
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