Overbought and Oversold RSI Readings
When is an overbought RSI reading bullish and when is it bearish?
One classic interpretation of momentum indicators is that of
overbought and oversold. Normally these are quite good signals when
used within a consolidating market although mere oversold or overbought
readings should not be used to buy or sell (respectively) without other
forms of analysis and preferably in shorter term time frame charts.
However, these overbought and oversold extremes can be useful within
trends also. In this type of interpretation it is vital that only
trades in the direction of the trend be taken.
First we should remind ourselves of the definition of a trend.
Uptrend: is a sequence of higher highs and higher lows. Frequently,
though not always, a trend support line can be drawn across the lows
Downtrend: is a sequence of lower lows and lower highs Frequently,
though not always, a trend resistance line can be drawn across the highs
A good reversal signal at the end of a trend may well be the break
back below the support line in an uptrend or above the resistance line
in a downtrend. In addition, to confirm the reversal completely a break
of the last major swing low in an uptrend or the last swing high in a
downtrend will also cause the uptrend to be complete.
The following chart is that of the daily Euro-Dollar chart which
clearly has shown a strong and persistent uptrend over the course of
both last year and this year. Note how all the major lows remained
above the previous low in the move and this was accompanied by higher
highs in all cases. Very clearly this can be described as a major
uptrend.
Below the chart I have added Rapid RSI. I choose this form of RSI
since it is more volatile and reaches overbought and oversold extremes
more frequently than the traditional Welles-Wilder formula.
What can we deduce from the chart?
Well, at the left of the chart price was actually seeing a sideways
trading range. Both overbought and oversold provided good signals. At
these extreme readings, if the 4-hour and hourly charts also showed
reversal signals they would have been worth following.
What I do want to point out is that overbought readings of RSI in an
uptrend need not necessarily mean that the price is actually
overbought. Unless they are accompanied by bearish divergences I tend
to look at overbought readings as actually meaning "the market is still
bullish."
This does not always mean that price will continue higher and in
most cases there is a pullback, but note how on those occasions that
when RSI reached oversold while price has not penetrated the last low
point, then it actually provides an excellent buying signal.
You will still need to confirm those oversold signals in the shorter
time-frame charts, and it may well be worth combining these signals
with the support and resistance supplied by an analytical forecaster.
However, very clearly the mere fact that in an uptrend, following a
price high that is marked as overbought by RSI, the move to oversold
can be an excellent signal to take advantage of the next leg higher.
Now, we have just seen RSI move to overbought at the 1.4966 high.
There is one difference however which is that this overbought level has
produced a bearish divergence and at a time when price is poised just
above a support line that has run from the 1.3359 corrective low.
Breach will suggest the trend is complete and take price down towards
the 1.40-1.41 area. This should cause a correction as the market
remains very bearish Dollars but the technicals are suggesting that a
new high in the Euro will not be seen.
The use of (Rapid) RSI in this manner does highlight an alternative
method of using overbought and oversold extremes to great effect.
Ian Copsey
Global Forex Trading
http://www.gftforex.com | 
