RSI Indicator LIES! Untold Truth About RSI!
The Relative Strength Index (RSI) is a classic technical indicator that is applied to identify the overbought and oversold states of the market.
While the RSI looks simple to use, there is one important element in it that many traders forget about: it's a lagging indicator.
This means it reacts to past price movements rather than predicting future ones. This inherent lag can sometimes mislead traders, particularly when the markets are volatile or trade in a strong bullish/bearish trend.
In this article, we will discuss the situations when RSI indicator will lie to you. We will go through the instances when the indicator should not be relied and not used on, and I will explain to you the best strategy to apply RSI.
Relative Strength Index analyzes the price movements over a specific time period and displays a score between 0 and 100.
Generally, an RSI above 70 suggests an overbought condition, while an RSI below 30 suggests an oversold condition.
By itself, the overbought and overbought conditions give poor signals, simply because the market may remain in these conditions for a substantial period of time.
Take a look at a price action on GBPCHF. After the indicator showed the oversold condition, the pair dropped 150 pips lower before the reversal initiated.
So as an extra confirmation , traders prefer to look for RSI divergence - the situation when the price action and indicator move in the opposite direction.
Above is the example of RSI divergence: Crude Oil formed a sequence of higher highs, while the indicator formed a higher high with a consequent lower high. That confirmed the overbought state of the market, and a bearish reversal followed.
However, only few knows that even a divergence will provide accurate signals only in some particular instances.
When you identified RSI divergence, make sure that it happened after a test of an important key level.
Historical structures increase the probability that the RSI divergence will accurately indicate the reversal.
Above is the example how RSI divergence gave a false signal on USDCAD.
However, the divergence that followed after a test of a key level, gave a strong bearish signal.
There are much better situations when RSI can be applied, but we will discuss later on, for now, the main conclusion is that
RSI Divergence beyond key levels most of the time will provide low accuracy signals.
But there is one particular case, when RSI divergence will give the worst, the most terrible signal.
In very rare situations, the market may trade in a strong bullish trend, in the uncharted territory, where there are no historical price levels.
In such cases, RSI bullish divergence will constantly lie , making retail traders short constantly and lose their money.
Here is what happens with Gold on a daily.
The market is trading in the uncharted territory, updated the All-Time Highs daily.
Even though there is a clear overbought state and a divergence,
the market keeps growing.
Only few knows, however, that even though RSI is considered to be a reversal, counter trend indicator, it can be applied for trend following trading.
On a daily time frame, after the price sets a new high, wait for a pullback to a key horizontal support.
Your bullish signal, will be a bearish divergence on an hourly time frame.
Here is how the price retested a support based on a previous ATH on Gold. After it approached a broken structure, we see a confirmed bearish divergence.
That gives a perfect trend-following signal to buy the market.
A strong bullish rally followed then.
RSI indicator is a very powerful tool, that many traders apply incorrectly.
When the market is trading in a strong trend, this indicator can be perfectly applied for following the trend, not going against that.
I hope that the cases that I described will help you not lose money, trading with Relative Strength Index.
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Rsistrategy
Detection of Peaks and ValleysExplanation:
Detection of Peaks and Valleys: Initially, the RSI (Relative Strength Index) is calculated based on a selected price source. Then, any change in RSI that exceeds the specified percentage threshold is considered a peak or a valley point. These points are visually represented on the chart with green and red triangles.
Identification of Divergences: Differences between peak and valley points are examined. A negative divergence occurs when peak values increase on the price chart while decreasing on the indicator chart. Conversely, a positive divergence occurs when valley values decrease on the price chart while increasing on the indicator chart.
Generation of Buy and Sell Signals: When a negative divergence is detected, a sell position is opened and held until the specified take profit level is reached. Similarly, when a positive divergence is detected, a buy position is opened and held until the specified take profit level is reached.
This strategy utilizes the RSI indicator to assess the momentum and strength of price movements and generates buy and sell signals based on the detection of divergences. Parameters such as take profit levels and others can be adjusted by the user.
03:17:46 'Divergence Strategy 1' saved.
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Price overextension: misconceptions and common mistakesPrice overextension remains a widely misunderstood concept in trading, causing both novice and seasoned traders to make errors in their decision-making. This misinterpretation often leads to placing trades in the wrong direction or, equally detrimental, overlooking profitable opportunities.
In essence, price overextension signifies that the market has undergone a rapid and excessive movement in one direction. Such movements are often perceived as unsustainable. Numerous indicators, such as Stochastic, RSI, Bollinger Bands and many other, attempt to identify such "abnormal" price movements so traders could capitalize on them. Despite variations in statistical methods and calculations, their common goal is to detect instances where price went or down too much and is likely to reverse.
In this discussion, I will use Relative-Strength-Index (RSI), a popular indicator, to convey my perspective on price overextension. While some traders argue for customization, the elusive question of "how" often remains unanswered. From my experience, there are no universally perfect settings that consistently yield optimal results.
I’ll draw my examples from the recent SPY bar chart (February 2024).
The first misconception
The first misconception is that if price is overextended it is time to immediately start looking for a trade in the opposite direction. The most important phrase here is “start looking”. Many beginners misinterpret this as an invitation to commence trading, leading to the premature initiation of short positions during perceived market "overextension" and vice versa.
So, the first and foremost important advice is to never try guessing top/bottom based on one indicator or gut feeling. Simple as it seems I remember many times breaking this rule myself because the temptation was too strong. It rarely ended up well.
On the graph, I've highlighted three recent instances where the RSI exceeded 70 (indicating overbought conditions). What stands out is that, following each occurrence, the price surged significantly before consolidation set in, inflicting losses upon short traders.
Even experienced traders, who look for confluence of signals, may fall into this trap. In the first two examples, bearish candlestick patterns failed to prevent subsequent price increases. Most likely, those candles were “created” by weak hands traders, who tried to short market, while it was actually controlled by strong buyers.
These instances could have been avoided by considering the daily graph, revealing a robust bullish context – price was in an uptrend, one-time-framing up on weekly. There were couple of moments when bears gained short term control (Tuesdays 13th and 20th) but they never could take the previous week low; bulls always confirmed their control.
The second advice is to avoid trading against higher level context. While sometimes those trades might work the result is usually mediocre and most of the times you’ll simply lose. If you really wish to trade against context you need to construct a solid dossier of evidence, supporting your trade.
The second misconception
What is the second misconception? It is that when price overextended it is not time to go with the market. In this scenario, traders refrain from initiating long trades after RSI indicates overbought conditions, potentially causing them to miss profitable opportunities. It might not hurt your account but who likes missing good opportunities?
Surprisingly, seizing these trades correctly is not much harder than any other trade. It simply requires prudence and discipline and getting rid-off cognitive biases. For example, in the second example on the graph a trader could win up to 1% if he played off gap-up open after seeing that the new price has found acceptance.
Conclusion
It is possible to build a profitable strategy that relies on “price overextension” concept. However, it demands more than a cursory examination of a single indicator and adherence to textbook candle patterns. Personally, I reached a point where I entirely abandoned the use of RSI and similar tools because, instead of providing clarity, they seemed to cloud my thinking.
Opting for a more effective approach involves keenly observing actual market behavior, which often defies conventional expectations. Study of high-level contexts, understanding key levels, and discerning confluence in price action signals on lower timeframes consistently prove invaluable. This method helps steer clear of common pitfalls and contributes to enhancing overall trading results.
Trading Strategies with the Relative Strength IndexTrading Strategies with the Relative Strength Index
The Relative Strength Index (RSI) is a cornerstone in the world of technical analysis, assisting traders in capitalising on momentum-based opportunities. This article delves into three sophisticated RSI strategies, shedding light on how to deploy the indicator in different trading scenarios.
RSI in Trading Explained
The Relative Strength Index is a momentum oscillator that measures the velocity and change of price movements. Developed by J. Welles Wilder in 1978, the RSI oscillates between zero and 100. Typically, and by default, it is set at a 14-period time frame, meaning it computes momentum based on the last 14 price bars, whether they're days, hours, or minutes, depending on the chart.
The RSI is primarily used to identify overbought or oversold conditions. An RSI value above 70 suggests that an asset may be overbought, indicating a potential sell signal. Conversely, an RSI value below 30 signifies an oversold condition, suggesting a possible buying opportunity.
Moreover, sustained moves above the 50 mark indicate bullishness, while the index being below 50 is typically bearish. While many traders use these basic thresholds, the RSI is versatile and can be combined with other indicators and strategies for more comprehensive trading setups.
To get started with the RSI and the strategies in this article, head over to FXOpen’s free TickTrader platform. There, you’ll find each of the tools discussed waiting for you.
Best RSI Indicator Settings
The default setting for the RSI is a 14-period calculation, which works well for capturing short-to-medium-term price movements. However, traders can adjust this to suit their trading style. For those looking for more frequent trading opportunities, a shorter period like 7 or 9 can be used to generate quicker signals.
Conversely, for swing traders or investors interested in longer-term trends, a setting of 21 or even 28 periods could be more appropriate. It's important to note that shortening the RSI period will make it more sensitive, increasing the frequency of signals, while lengthening it will smooth out the data and produce fewer but potentially more reliable signals.
RSI With Hull Moving Average Confirmation
Incorporating Hull Moving Averages (HMA) into an RSI-based strategy offers traders an additional layer of confirmation for entry and exit points. In this approach, traders can use both a 9-period and a 21-period HMA alongside an RSI that has crossed below the 70 level for a bearish scenario or above the 30 level for a bullish scenario.
Entry
Traders can look for a 9-period HMA and 21-period HMA crossover within a few bars of the RSI crossing the designated overbought or oversold level. When an HMA with a shorter period crosses above the HMA with a longer period, it’s usually considered a buy signal and vice versa.
Stop Loss
Stop losses may be positioned above or below a nearby swing point. This provides a buffer against sudden market reversals while keeping risk manageable.
Take Profit
Profits are typically taken at an identified support or resistance level.
Another option is to exit when the RSI crosses into the opposite extreme zone (from overbought to oversold or vice versa).
A subsequent HMA crossover against the trade direction can also serve as a signal for profit-taking.
The advantage of using Hull Moving Averages for confirmation is their responsiveness to price changes without the noise often associated with other types of moving averages. This strategy aims to capitalise on more robust signals by combining the trend-following characteristics of HMA with the momentum signals of the RSI.
Stochastic and RSI Indicator Strategy
In this RSI trading strategy, the focus is on combining the RSI with the Stochastic Oscillator for enhanced market insight. Both are momentum indicators, but they evaluate different aspects of price action, making them complementary when used together.
Entry
Traders can consider entering a trade when the RSI is above 50 for a bullish scenario or below 50 for a bearish one.
The entry signal may be further confirmed when the Stochastic Oscillator's %K crosses the %D line in the same direction as the RSI reading but below 80 and above 20.
Stop Loss
Stop losses can commonly be placed above/below a nearby swing point.
Take Profit
Taking profits may occur at a clearly defined support or resistance level.
The value of this strategy comes from the synergistic effects of combining RSI and Stochastic Oscillators. While the RSI measures the speed and change of price movements, the Stochastic helps to validate or negate the RSI's signal by considering where the current price is relative to its range over a particular period. This dual-layer approach aims to minimise false signals and improve the probability of a successful trade.
RSI Pullback Strategy
In a clear trending market, identified by a series of higher highs and higher lows for an uptrend or lower highs and lower lows for a downtrend, traders can employ a 7-period RSI for an RSI Pullback Strategy. Ideal when using the RSI for day trading, this strategy focuses on exploiting price retracements, offering an optimised entry point in an already established trend.
Entry
During a pullback in price, traders look for the RSI to enter overbought or oversold territories.
An entry signal may be considered when the RSI crosses back above 30 during an oversold condition or below 70 during an overbought condition.
Stop Loss
Similar to other strategies, stop losses are generally placed near a recent swing point for reasonable risk management.
Take Profit
Profits can typically be taken at an identified support or resistance level.
Alternatively, traders may opt to close the trade at the most recent high or when the RSI crosses into the opposing area (from overbought to oversold or vice versa).
The use of a 7-period RSI allows for a more responsive reaction to price changes, making it suitable for capturing short-term pullbacks. By entering when the RSI reverses from extreme levels, traders aim to rejoin the prevailing trend at a more favourable price.
The Bottom Line
Exploring advanced RSI strategies can be a game-changer for traders aiming to capitalise on market momentum. The strategies here offer a more comprehensive approach than merely adhering to traditional overbought or oversold conditions. To put them into practice, modify them so they suit your trading approach, and experience them in a real trading environment, consider opening an FXOpen account, where you'll find all the tools and platforms necessary to take your trading to the next level. Good luck!
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