Understanding ranging markets and the Relative Strength Index (RSI)

Reading charts is very important in trading because, after all, success largely depends on whether you can identify trends in the market and swing points where the price is about to reverse. In this lesson, we will discuss how to spot assets that are being overbought or oversold and their price trend is about to take a turn.

A ranging market happens when the price of an instrument moves between a maximum, which is called a resistance level, and a minimum, which is the support level. You should notice this trend regardless of the time frame you pick for your chart and it tells you that traders are fairly confident of the asset’s value. So, when the price gets closer to the resistance level, they feel it’s overbought and they start selling whereas, on the other side of the spectrum when it’s close to the support level, they acknowledge it’s undervalued and oversold and they correct upwards. What could change this wave-like chart, is a report or a momentum built in anticipation of a report which suggests that the instrument’s value needs to be reviewed and resistance or support levels are no longer valid.

So how do I decide when to place an order and how does RSI help?

A trader’s most important skill is knowing when to buy or sell. In a ranging market, you should consider buying close to the support level, because the price is likely to bounce back up. Conversely, sell near the resistance level where the price is expected to start falling. To minimise the risk of an asset breaking through the barriers, e.g. when a report changes the market’s perception of its value, you can set up “take profit” and “stop loss” orders which will protect your investment.

A traders’ biggest fear is a reversing market. This happens when the market previously traded in one direction but then starts moving confidently in the opposite direction. This usually happens, when a new report is released and traders feel the instrument’s price is no longer correct. So, is there any tool to help you identify when an asset goes into “overbought” or “oversold” territory so you can keep an eye out on it? The Relative Strength Index (RSI) is what you’re looking for.

RSI captures momentum. It’s an oscillator that ranges between 0%-100% and is calculated via a complex mathematical function which compares recent losses and gains in order to identify whether an instrument is overbought or oversold. Roughly speaking, once the RSI goes above 70%, the instrument is overbought and you should keep an eye out with a view to selling. When it moves close to or below 30%, the instrument is oversold and the price is expected to rise so you should buy. Experienced traders take an even more nuanced approach, e.g. in an upward trend, they will consider the instrument oversold at higher than 30%.

Needless to say, these chart trends as well as the RSI are simply indicators of where the market is going, provided there isn’t some other factor to cause a price correction. You should learn how to interpret and use them but technical analysis isn’t the end-all of trading. Always, keep an eye out for fundamental analysis outcomes, reports and geopolitical turbulence that could affect your investments.

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