Recklessly opening trades when the RSI indicator falls below 30 or rises above 70 is the worst thing you can do. Overbought and oversold levels often give hasty or false signals. And the lower the selected timeframe, the more skeptical you should be about the indicator.
To increase your chances of successfully opening a trade, use a three-step trading strategy:
Step 1. Identify the Trend
Any trading strategy should start with this because trading against the trend is too risky and will most likely bring more losses than profits.
Identify the major market trend. To do this, you need a high timeframe. Give preference to daily charts. Here, the general direction of the market will be better noticeable, while overbought and oversold signals will be more accurate.
Identifying the major trend will help you filter out false and inaccurate signals from the RSI indicator. For example, on a downtrend, it is best to react only to a rise of the indicator above 70 and open a short position afterward. Such a trade will be directed towards the main trend, and you will not have to trade on riskier pullbacks.
Step 2. Build Price Levels
If you get the oversold/overbought signals far from major support or resistance lines, they might be false. After determining the direction of the trend, make sure to draw the major price levels. You can do it manually using the previous highs and lows or use the free indicator built into MetaTrader 4 platform. You can also stretch the Fibonacci grid that will set the required price levels.
It is better to open trades using the RSI indicator only on the set lines. For example:
- Open a sell trade if an overbought signal occurs in the area of the resistance line
- An oversold reading below 30 in the support area gives a buy signal
Step 3. Use the RSI Indicator
Once you set the main price levels, check the overbought and oversold signals It is important to use all three steps of this strategy simultaneously. Some indicators confirm others. Without confirmation, you risk starting to open trades at random.
The breakout of levels 30 and 70 in the RSI indicator is not a reliable signal itself. The oversold level may continue to fall while the overbought level may rise. When the price breaks the support line to the upside or resistance to the downside, you receive the required confirmation of your RSI indicator signals.
This strategy does not limit the ways you can apply the overbought and oversold levels. Many traders use them as confirmation of other signals such as breakouts in reversal candlestick patterns and figures. You can use one or more of these methods. But you should remember that the best signals are those that have been confirmed by other indicators.
Frequently Asked Questions
Is oversold bearish or bullish signal?
Traders sometimes consider oversold a sell signal, but it's a signal that an asset is situated at the bottom of its recent price levels on the chart. That's why oversold tells about the upcoming reversal on the market, but other signals should confirm it.
Most accurate overbought/oversold indicator
The two most popular overbought and oversold indicators are RSI and Stochastics. Each has its advantages and disadvantages, but combining them with other signals is better, as none of them gives you a 100% guarantee.
What is the overbought oversold strategy?
The best overbought/oversold system is selling highs and buying lows after you identify the market trend. The next step is to wait until the RSI is more than 70 in a bullish market and open a short position or lower than 30 in a bearish one and open long.