Relative Strength Index – Overbought and Oversold Markets

The Relative Strength Index (RSI) is probably one of the most important indicators for binary options traders, and all of them, have probably, tried to incorporate this indicator into their trading decisions.

This indicator, the RSI, is usually a part of all trading platforms, which can be found either under the oscillator or momentum indicators, whereby traders should use the default 14 period. The indicator will take into account the candle chart, more precisely 14 last candles to determine the closing levels based on this information.

How does the RSI Interpret the Market?

The RSI indicator uses the standard levels which are available with all brokers and which are called the 70 and 30 levels. The 70 level simply indicates when the market is overbought, while 30 level represents the opposite, showing when the market is oversold.

According to this theory, the best would be if traders would simply buy put options if the indicator is pointing towards the 70 level, and place call options if it is more in the 30 level area. Is it really that simple?

This is a sure and proved recipe only when a consolidation pattern has been identified. To make a successful trade with this indicator, traders should focus on bigger time frames in order to get a range (triangle) on the chart, and only after that, it is recommended to trade it on smaller timeframes with the RSI indicator. The video we provided in this article, illustrates a real-time example of trading RSI on the most traded currency pair EURUSD. The video also shows how to integrate the indicator to other currency pair charts as well.

RSI Helps You to Find Out Whether an Asset is Overbought or Oversold

The RSI oscillator displays extreme levels as supposed to do. It will always show overbought and oversold levels, but, traders need to bear in mind, that it only works when there is arrange or when the market consolidates.  Sometimes traders do not know how to find a range, but they can do so by trading patterns which have a fair chance to pick up on ranging conditions. Another way to find them is observing trading sessions you would like to trade. The Elliot Waves theory suggests that two corrective ranges emerge from an impulsive movement, and these ranges or waves usually follow the lower-degree impulsive movements.

For example, when you find yourself, after the extension, in a third move that is extending, take a look at the previous wave, which will give you a hint of how the fourth wave will move. If the second wave exhibits a plain correction, you can expect the fourth wave to be complex and that it will need more time, whereby you can create a range. A bullish impulsive movement indicates that a call option should be bought as the RSI reaches the 30 level area, whereby the expiry date should adjust to the timeframe which was set for the RSI.

Catch the Ideal Strike Price with RSI

The Asian session is very favorable when looking for ranges, since the Asian markets are moving slower, in comparison to European and American trading sessions. Use the lack of liquidity in the Asian session market to your benefit and create a range which will indicate the perfect time to strike for the perfect price. Identification of oversold and overbought markets is far easier with a creation of ranges and the RSI, the indicator who instantly picks up on the overbought and oversold level which gives traders the opportunity to strike when the price is right.

Traders should bear in mind that the oscillator is detached and not to be found on the main chart, but it opens in a separate window below the chart whereby traders can customize the settings or periods how they want. Nevertheless, it is recommended to stay with the default 14 periods which guarantees that the indicator will examine 14 different candles. If traders set a bigger number of candles to be examined, the oscillator will take into account more candles which means that the RSI indicator will be flatter which can make it difficult to reach oversold and overbought levels.

Divergence and RSI

When trading binary options, it can be quite interesting to observe the divergence between the price and indicator, when using the RSI indicator, but this phenomenon is not that common and appears only in special circumstances. Nevertheless, the Binary Options Academy is going to examine that factor as well in order to give you a more comprehensive outlook of trading with RSI.

The RSI displays different values for different timeframes and expiry periods, and it is common knowledge that an asset can be overbought in one, and not in the other timeframe. This means that the expiry date for any asset traded is different on the daily chart than an asset which is being observed on an hourly chart, and the RSI has a dual here by examining both situations. The RSI is a strong trading tool when a trader knows how to incorporate it in its trading, but also its limits.

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References and Further Reading:

  1. How rewarding is technical analysis? Evidence from Singapore stock market (Wing-Keung Wong , Meher Manzur & Boon-Kiat Chew)
  2. What Does the Stock Market Tell Us About Real Estate Returns? (Joseph Gyourko, Donald B. Keim)
  3. Forecasting stock indices: a comparison of classification and level estimation models  (Mark T. Leung, Hazem Daouk, An-Sing Chen)
  4. The profitability of moving average trading rules in South Asian stock markets  (Abeyratna Gunasekarage, David M Power)
  5. Modeling and simulation of the market fluctuations by the finite range contact systems (Junhuan Zhang, Jun Wang)

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