It is so simple to jump into trading usingthe RSI indicator without testing different settings, or educating yourself on the properinterpretation of this indicator, because of a desire to grab money quickly! As a result, the RSI has become one of themost widely misused indicators.
Once understood and correctly applied, theRSI has the ability to indicate whether prices are trending, when a market is overboughtor oversold, and the best price to enter or exit a trade.
The relative strength index (RSI) it’s amomentum oscillator that measures the speed and change of price movement.
The RSI oscillates between 0 and 100 and it’soften used to measure overbought and oversold conditions in the market, divergence or itcan be used to identify the general trend.
Basically, the RSI is analyzing the totalnumber of down periods versus the total number of up periods and plots the average on theRSI curve.
There are many different techniques for usingit, but it can be altered depending on your specific needs.
An overlooked method of using RSI is the useof trend lines directly on the oscillator itself in much the same way that they areused on price charts.
Trend lines are one of the most common andhelpful tools in a trader's kit.
They are used to show the price upwards, downwards, and sometime sideways, movement.
Confirmed trend lines are drawn by connectinga cycle low, or high, with at least two other of the highest or lowest points on a chart, to create a line of best fit.
Connecting rising swing lows of the RSI inan uptrend or lower swing highs in a downtrend, traders can find trading opportunities withstrong risk to reward setups.
Because RSI measures the surge in closingprices, when RSI changes direction and either breaks above or below a trend line, a significantmove in price can result.
So, we’ll use the RSI indicator to showus if the prevailing trend has ended and a new trend is underway.
We’re not going to measure the overbought/oversoldconditions or as a crossover system, we’re going to take it one step further and lookfor a break in momentum of the prevailing trend.
What I mean by this is that we’re goingto look at the changes in prices relative to the changes in the peak and the valleythat the RSI indicator will generate.
Trend lines placed on this oscillator providean additional level of precision as well as additional trade setups.
Because the signals are leading rather thanlagging, stops can be placed relatively close to the entry point.
This allows for a good risk to reward tradingopportunity.
The RSI-trend line approach works best onhigher timeframes but it can be used on any time frame, for day trading for example.
The rules of this technique are straightforward, we only need to connect the most recent RSI peaks or valleys with a trend line and wesearch for a breakout of the trend line, which will warn us that the market has lost itssteam and the prevailing trend has lost its momentum.
There is one more condition that needs tobe satisfied in order to enter a trade, we need for the price to still be trading belowits trend line, so we’ll need the RSI trend line to be broken, and the price to be tradingbelow its trend line.
This is the most important principle in orderfor the RSI-trend line strategy to work because it tells us there is also a divergence betweenmomentum and price.
Momentum always goes ahead of price and that’sthe reason why this strategy can yield a great return.
The breaking of an RSI trend line usuallyprecedes the break of a trend line on the price chart, providing an advance warningof a reversal.
Therefore, recognizing the break of the RSItrend line can be an important and profitable indicator that the price direction is aboutto change.
This is a leading signal.
a leading signal appears before the new trendor reversal occurs.
RSI, in its nature, is a lagging indicator.
Lagging indicators only give signals afterthe price change is clearly forming a trend.
The downside is that you’d be a little latein entering a position.
Often the biggest gains of a trend occur inthe first few bars, so by using a lagging indicator you could potentially miss out onmuch of the profit.
That’s, when trading the RSI trend linebreakout, you’ll get leading signals.
Now you’re probably saying to yourself, “Oh, I’m going to get rich with leading indicators!” Since you would be able to profit from a newtrend right at the start.
You’re right.
You would “catch” the entire trend everysingle time if the leading indicator was correct every single time.
But it won’t be.
When you use leading indicators, you willexperience a lot of fakeouts.
That’s why it’s important to look closelyat the price action.
If you would take a trade every time you spota RSI trend line breakout, you would soon find out that the outcome is not as expected.
The RSI trend line has leading qualities, but after all it’s still an indicator.
You need to analyze the price.
You need to draw key support and resistancelevels, to identify the trend and take RSI trend lines in the direction of the main trend.
Here is a common mistake.
Many traders that implement the RSI trendline breakout approach, use it as a reversal signal.
They see an upward trend, they spot a RSItrend line breakout and go short.
This could work, yes, but it’s not the mostconsistent way of using it.
I use it in a more conservative way.
When I spot the same uptrend, i search forRSI trend line signals that offer buy opportunities.
I have zero interest in RSI signals indicatingshort trades.
I go with the main trend.
In GBPUSD chart, we noticed some RSI trendline breaks.
The use of the trend line provided additionalvisual confirmation that a trade opportunity is near.
The use of trend line breaks gave buy signalsa few candles before the actual move.
In this another chart, we can have a representationof how a short setup would look like.
We have the price making lower lows and lowerhigh, so we are definitely in a downtrend.
We added the main support and resistance levels.
Then we identified the RSI trend line breakouts.
In terms of stop loss level, a common practiceis to use the candle on which the RSI broke its trend line, so in the case of our shortsetup our SL would be above that candle.
In real time trading, this isn’t best practice.
That’s why I rely on recent market swings.
I aim to place my stop loss above an importantswing.
If you prefer a better visualization of thetrend, add a long term moving average, and take trades in its main direction.
Here are other examples of RSI trend linetrades.
Regarding the settings, or better said, theperiod of RSI.
RSI like many other oscillators is defaultedto a 14 period setting.
This means the indicator looks back 14 barson whatever graph you may be viewing, to create its reading.
Even though 14 is the default period, thatmay not make it the best setting for your trading.
Normally short-term traders use a smallerperiod, such as a nine period RSI, to replicate shorter term movements in the market.
Longer-term traders may opt for a higher period, such as a 21 period RSI or even 50.
Depending on your trading style, you can loweryour RSI to increase sensitivity or you could raise it to decrease sensitivity.
Keep in mind that on lower timeframes, withlower RSI settings, you will get a lot of false signals, because the indicator willhave increased sensitivity.
So, maybe it’s better to increase the valueof the RSI if you want to back test this technique on smaller timeframes.
If you want a smoother analysis, with lessnoise, go on higher timeframes.
Here you could use a lower period on the RSI, which will offer more trend line opportunities, but you could also adopt a less sensitiveapproach, by using a higher period RSI, like the 21 for example.
The key is to back test and find the bestapproach that works with your trading style.
The RSI is a powerful tool that can offera great assistance on when to buy and when to sell.
Sometimes it can also predict the trend otherindicators are too slow to acknowledge.
An important tip is that you shouldn’t chasethe trades, let them come to you.
RSI is an indicator and just follow the price.
You should be patient and wait for a clearbreak of its trend line.
Maybe sometimes, you should wait to see howthe first candle acts after the breakout and after that take your trade.
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Until next time.
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