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Sunday, May 8, 2011

RSI



Although I am not a great lover (far from it) of technical indicators I do use some of them as an extra tool in my trading. I am absolutely sure that you can see any indicator can show you in the charts. And it is needless to say that all indicators are lagging and you should find your ways (or follow mine) to determine where price is headed in the future. Still, I do use indicators and today I wanted to give you a few thoughts on how you can use rsi indicator in trading a trend and a range. 

When you finish this article read my previous posts too:

The first method: traditional overbought and oversold stuff

I have my own favorite methods and not always use the classical ways of trading indicators. However, the first method is pretty traditional and it is to look for overbought and oversold levels in a trend or counter trend move. I do not have enough patience to explain about the values of rsi (I will expand the post later), you can read about them in most forex sites that deal with technical analysis. However, any value (if we use 14 day rsi) that is close to 30 and below the level can be considered oversold and any value that is close to 70 or above the level can be considered to be overbought.



This would mean that if we are in a range you would be looking how to sell a security if the indicator reaches 70 level and you would be looking how to buy a security if it reaches 30 level. In a trend the indicator very often goes beyond these levels (is overbought in an uptrend and oversold in a downtrend) for a prolonged period of time and is not a very reliable indicator to trade against the trend. It is however, pretty good to enter a trend if the rsi shows overbought levels in a downtrend and oversold levels in an uptrend.


If you looked at silver daily chart with Relative Strength Index at 14 on you would see that on the 5th of May indicator reached oversold level with a value of 28.89. We also see from the chart that silver has been in an uptrend, which means that we should be looking for opportunities to seek how to go long. So, you go to lower time frames for example 1 hour chart and search for confirmations to buy there. I like waiting for 123 patterns on 1 hour or 4 hour charts to go back in the direction of the trend. Long bullish hourly candles can also be an indication that a counter trend rally is over and we can come back to long entries (See the chart below about the possibility of going long in silver).


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Trading hidden divergence

Another way to use the indicator, which I like and it is not a very traditional way to do it is to wait for hidden divergence in order to go back in the direction of a move (if you believe it is going to continue). Divergence is basically a discrepancy between the action of price and the action of an indicator for the price. In an uptrend, it means the price is going higher and the indicator shows lower values. So, there would be a divergence if you saw higher highs in a security and lower highs in the indicator. (See the example below with aud/usd pair). When you see it in a range, it could be a good possibility to think of shorting a security. Not a good idea to do it when a long term uptrend is in place!



However, if you have a long term uptrend (or a swing up) in place you wait for hidden divergence to enter the market. What you want to see is again a discrepancy between price and indicator. This time (if we take uptrend) the price makes higher lows and indicator makes lower lows. It is a hidden divergence and you should look for opportunities to go up. A hidden divergence usually forms when you have sharp correction in an uptrend or downtrend and these present you with good possibilities to reenter the trend with much favorable prices than you would pay if you traded a breakout of higher highs in an uptrend or lower lows in a downtrend. When you see hidden divergence formed in a trendy market it may mean that a counter trend move has overextended itself and market participants will increase their positions in the direction of a prevailing tendency. And so should you! Again you could wait for 123 structure or other technical pattern which you would use as a reversal signal in a counter trend move.


Best time frames for hidden divergence in a swing

I prefer using 4 and 8 hour charts for waiting of a hidden diversion in a trend. These time frames are more accurate and you have less market noise in the indicator. I also reduce the noise by taking 21 period rsi instead of 14 period. The reason the same, the smaller the period the more noise you have. And if you look at 5 or 1 minute frames most of what you see will be noise. So, do not mess around with those minute charts. They are good for determining the best entry levels, but tell you nothing of a prevailing market trend and you make serious money by trading big moves. So, do not lose your focus in playing around with minute frame charts. Keep your focus on direction. 

Conclusion

rsi indicator is one of the best among what is currently available for a market technician. However, it should only be used as a supplementary tool in technical analysis for defining overbought/oversold levels in a range and in adding to a position in a trend after a correction when hidden divergence is formed. Focus should be on larger time frame charts and smaller time charts should be used only for determining best entry levels.





Disclaimer
Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.