RSI can be useful to understand the over-bought or over-sold condition in the Market and individual Stocks. The rule is that if the RSI moves above 70 points means that the stock is becoming overbought, whilst a drop below 30 points marks an oversold condition. The other usage of the RSI is to see whether it trends in tandem with the the market. If it does trend in the same direction as the Price, then the trend appears to be strong. But if the RSI is diverting from the trend of the stock then it is an indication of a trend reversal.
In theory this might sound fantastic, but in reality it appears to be a fiction than factual. Therefore you need to master it to reap in the benefits. However it is a useful tool to understand the pulse of the market.
Misconceptions
Many traders treat overbought and oversold scenarios as immediate trend reversals. This is more a misconception than the reality. The reason why a stock move into the overbought zone is because there are more buyers as against the sellers. Buyers do not pay the same price for the stock to move up, they pay higher, as such the RSI move up. But the prices can't always go up, and at some point the buyers get exhausted, then the Sellers take over and the stock comes down to the extent of Sellers being exhausted, thus becoming oversold. For the risk savy trader, the rising or falling RSI is a great tool to follow, with tight stop losses.
Sri Lankan Market
In the Sri Lankan Market the overbought condition becomes riskier, when the RSI goes over 80 points. Conversely if the RSI falls below 20 it is riskier for the oversold condition. The difficult task is to buy just because the RSI falls below 20 points, and sell because the RSI move over 80 points. Due to this reason you need to follow the RSI together with trend lines, moving averages, support and resistance points, and waves.
RSI and 9sma Trade Setup
Buy Rule
- RSI must cut above 50 points
- Price line must close above 9sma
Sell Rule
- Sell if the RSI moves above 70 points OR
- at a predetermine Level
Stop Rule
- Cut loss at the previous support.
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