As a trader, the most common complaint is entering at the right time. With the many variables in the market, it is difficult to pinpoint the right time. Even if we catch a potential setup, we can never be sure whether the markets will move in our direction. That is when the RSI Indicator can help clarify your decision.
Power of RSI to Get the Right Entries
One of the widely used technical indicators is the RSI Indicator, measuring the magnitude of recent price changes to see overbought or oversold conditions. This ranges from 0 to 100, where a reading above 70 can be interpreted as being overbought and any reading below 30 as oversold. The power of this indicator helps a trader spot possible reversals of the price to achieve better entries and exit at a more ideal time.
Although RSI isn’t a trading strategy by itself, it can be an excellent tool to enhance your existing trade setups. RSI combined with other indicators or chart patterns could make your trades stronger and raise the probability of success.
How To Use RSI for Better Entries?
Mike Bella Fury, a co-founder of a leading proprietary trading firm in New York, explains how traders can utilize RSI to identify entry points. Let’s take a look at how this works in practice with a real-world trade example shared by one of the firm’s traders, Ken.
The RSI Setup:
Ken, a trader from the company, found the perfect trade setup on the stock AFRM (Affirm Holdings). AFRM had been in an uptrend for several days straight, but on the charts, Ken saw something important.
- Stock Extended: AFRM was up eight out of the last nine days.
- RSI Over 80: On both the daily and the hourly charts, the RSI remained above 80, indicating the stock was becoming overbought.
It resonates with the mean reversion concept, where a market tends to revert to the mean after being highly overextended, but as trader Garrett from the firm points out, blindly shorting a stock just because it’s overbought can sometimes be dangerous in case of good stocks that are moving upward and keep going without any stop signals for a prolonged period.
Validation of the Setup through RSI
Ken did not jump into a trade. Instead, he used the RSI indicator to further confirm that the stock was indeed extended. The critical part is that RSI served as an environment filter—it helped Ken establish an overextended market environment, making the trade even more favorable for a potential pullback.
Multi-Time Frame RSI:
Ken checked the multiple time frames of daily, hourly, and intraday to validate the strength of the overbought condition. Both the 15-minute and 30-minute charts showed RSI readings above 80. This enhanced his confidence in the trade, as the stock was showing overbought conditions across multiple time frames.
Execution Strategy:
Once Ken established the stock was indeed overbought on multiple time frames, then it was entry time.
Entry:
As Garrett explains, sometimes it is simply too difficult to enter a short in the middle of an uptrend. So instead of getting caught up chasing the top with all its connotations of getting caught in frustration and risk, Ken waited until the stock looked like it may be showing early signs of fatigue.
- Setup the 15-minute chart: The key here was the 15-minute chart wherein Ken saw that the stock’s price was struggling around $41.30. For the break below the 15-minute candle low to confirm a turn of momentum, he waited.
Triggering the Short:
The short position was triggered when the stock broke below the $41.30 level. The price had retraced back to that level and could not sustain a reclaim. This signified that the short trade was legitimate, and at this juncture, Ken could add more to his position.
Managing the Trade:
Garret further goes to explain how one can hold the trades after entering. There are various methods for trailing stops and locking in profits, depending on your personal trading styles.
- Trailing Stops: There is one simple method to handle this trade by using a trailing stop. In this example, Ken can trail his stop based on the chart of 15 minutes by keeping a look on the price action, and change the stop when it shows signals of reversals.
- Targeting VAP: An alternative would be to target key levels of support or resistance through the use of VAP (Volume at Price). It could be that Ken had targeted a level of significant volume-based support as an exit point.
The Takeaway:
Using the RSI indicator effectively is about combining it with a strategy that fits your trading style. In this case, RSI helped Ken identify an overbought condition across multiple time frames, which allowed him to make a more confident decision to short the stock. It wasn’t about blindly relying on the RSI but using it as part of a larger setup.
The key takeaway is that you should use RSI as a supplementaly tool to your trading arsenal to confirm setups and add edge to your trades. Be it in a trending market or searching for mean reversion opportunities, RSI will help you make better decisions.
Conclusion
In a nutshell, the RSI indicator is a good tool that helps pinpoint better entry points for traders but should be used in tandem with a sound strategy. We see this clearly from the example of Ken’s trade, as the RSI offers confirmation, helps filter out false signals, and adds clarity to the decision-making process. Whether you trade stocks, Forex, or even crypto, if you use this RSI feature, you should be able to get an overbought/oversold sense and guide in your entries on a more specific basis.