Trading Relative Strength Index

Last time I wrote a little about using macd in trading and today I want to talk about relative strength index tradin. I have written one post on the subject and in the article I want to share more ideas on the topic. The two above mentioned indicators, together with 200 simple moving average are my favorite technical indicators. Although I consider myself a trader who mostly follows price action, I still like to place a few indicators on my charts. They usually confirm what I see on the charts and sometimes even start giving me signals about coming reversals prior to all other technical, fundamental and price action techniques.  

The thing I would like to start is a very simple idea that might help you to be a successful trader. The idea is that even if you have a medium good trading system and you are able to discipline yourself by following signals of the system you will most often end up having some profit. Of course, you need to back test your system. However, you should remember in this business it is your personality and not your trading system that matters most. And discipline is one of the keys that will open you the gates to success. 

There are hundreds approaches how one can use rsi indicator and to tell the truth you can also create hundreds of your ways to use the indicator. You should however find the best filtering ways to select only the best ones and avoid those that have a high potential for false signals. You will surely notice that the indicator (values 14 or 21) can pick up tops and bottoms pretty well (bottoms when it is below 30 and tops when the indicator above 70). So, if you are a swing or trend trader have this in mind.  

Statistics also shows that your chances for a profitable trade using rsi increases if you don’t simply use overbought or oversold values, but try to wait for divergences on the indicator. Even if you have an indicator showing you that the market is overbought it is only stating the fact about condition of the market. You, however, do not know for sure how much will the market continue rising. So, you do not want to immediately jump into the market and start selling right after it goes above 70 level or buying when it goes below 30 level. 

You want to see more signs of the market slowing down and more signs of reversal. A divergence could be one of the best confirmations of that after you have seen overbought or oversold level reached. Then wait for some important levels to be broken and trade a market reversal. 

Hope this short post was useful. I will update the topic in my future article.

More on the topic:

RSI

MACD

Trading moving average convergence divergence indicator

Moving average 

Technical analysis

Disclaimer

Trading financial markets carries a high level of risk, and may not be suitable for all investors. All information on the blog http://trend0.blogspot.com/ is of educational nature and cannot be considered as advice, recommendation or signals to trade in any financial markets.

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. 

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When you finish this article read my previous posts too:

Day trading strategies and rules for dummies

Spotting how market trends change

Best Forex trading system

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 5^th 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).

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.