It is so simple to jump into trading using the RSI indicator without testing different settings, or educating yourself on the proper interpretation of this indicator, because of a desire to grab money quickly!
As a result, the RSI has become one of the most widely misused indicators.
Once understood and correctly applied, the RSI has the ability to indicate whether prices are trending, when a market is overbought or oversold, and the best price to enter or exit a trade.
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The relative strength index (RSI) it’s a momentum oscillator that measures the speed and change of price movement.
The RSI oscillates between 0 and 100 and it’s often used to measure overbought and oversold conditions in the market, divergence or it can be used to identify the general trend.
Basically, the RSI is analyzing the total number of down periods versus the total number of up periods and plots the average on the RSI curve.
There are many different techniques for using it, but it can be altered depending on your specific needs.
An overlooked method of using RSI is the use of trend lines directly on the oscillator itself in much the same way that they are used on price charts.
Trend lines are one of the most common and helpful 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 connecting a 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 in an uptrend or lower swing highs in a downtrend, traders can find trading opportunities with strong risk to reward setups.
Because RSI measures the surge in closing prices, when RSI changes direction and either breaks above or below a trend line, a significant move in price can result.
So, we’ll use the RSI indicator to show us if the prevailing trend has ended and a new trend is underway.
We’re not going to measure the overbought/oversold conditions or as a crossover system, we’re going to take it one step further and look for a break in momentum of the prevailing trend.
What I mean by this is that we’re going to look at the changes in prices relative to the changes in the peak and the valley that the RSI indicator will generate.
Trend lines placed on this oscillator provide an additional level of precision as well as additional trade setups.
Because the signals are leading rather than lagging, stops can be placed relatively close to the entry point.
This allows for a good risk to reward trading opportunity.
The RSI-trend line approach works best on higher 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 we search for a breakout of the trend line, which will warn us that the market has lost its steam and the prevailing trend has lost its momentum.
There is one more condition that needs to be satisfied in order to enter a trade, we need for the price to still be trading below its trend line, so we’ll need the RSI trend line to be broken, and the price to be trading below its trend line.
This is the most important principle in order for the RSI-trend line strategy to work because it tells us there is also a divergence between momentum and price.
Momentum always goes ahead of price and that’s the reason why this strategy can yield a great return.
The breaking of an RSI trend line usually precedes the break of a trend line on the price chart, providing an advance warning of a reversal.
Therefore, recognizing the break of the RSI trend line can be an important and profitable indicator that the price direction is about to change.
A leading signal appears before the new trend or reversal occurs.
RSI, in its nature, is a lagging indicator.
Lagging indicators only give signals after the price change is clearly forming a trend.
The downside is that you’d be a little late in entering a position.
Often the biggest gains of a trend occur in the first few bars, so by using a lagging indicator you could potentially miss out on much of the profit.
That’s, when trading the RSI trend line breakout, 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 new trend right at the start.
You would “catch” the entire trend every single time if the leading indicator was correct every single time.
But it won’t be.
When you use leading indicators, you will experience a lot of fakeouts.
That’s why it’s important to look closely at the PRICE ACTION.
If you would take a trade every time you spot a 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 resistance levels, 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 trend line breakout approach, use it as a reversal signal.
They see an upward trend, they spot a RSI trend line breakout and go short.
This could work, yes, but it’s not the most consistent way of using it.
I use it in a more conservative way.
When I spot the same uptrend, i search for RSI trend line signals that offer buy opportunities.
I have zero interest in RSI signals indicating short trades.
I go with the main trend.
In GBPUSD chart, we noticed some RSI trend line breaks.
The use of the trend line provided additional visual confirmation that a trade opportunity is near.
The use of trend line breaks gave buy signals a few candles before the actual move.
In this another chart, we can have a representation of how a short setup would look like.
We have the price making lower lows and lower high, 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 practice is to use the candle on which the RSI broke its trend line, so in the case of our short setup 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 important swing.
If you prefer a better visualization of the trend, add a long term moving average, and take trades in its main direction.
Here are other examples of RSI trend line trades.
Regarding the settings, or better said, the period of RSI.
RSI like many other oscillators is defaulted to a 14 period setting.
This means the indicator looks back 14 bars on whatever graph you may be viewing, to create its reading.
Even though 14 is the default period, that may not make it the best setting for your trading.
Normally short-term traders use a smaller period, 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 lower your RSI to increase sensitivity or you could raise it to decrease sensitivity.
Keep in mind that on lower timeframes, with lower RSI settings, you will get a lot of false signals, because the indicator will have increased sensitivity.
So, maybe it’s better to increase the value of the RSI if you want to back test this technique on smaller timeframes.
If you want a smoother analysis, with less noise, 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 sensitive approach, by using a higher period RSI, like the 21 for example.
The key is to back test and find the best approach that works with your trading style.
The RSI is a powerful tool that can offer a great assistance on when to BUY and when to SELL.
Sometimes it can also predict the trend other indicators are too slow to acknowledge.
An important tip is that you shouldn’t chase the trades, let them come to you.
RSI is an indicator and just follow the price.
You should be patient and wait for a clear break of its trend line.
Maybe sometimes, you should wait to see how the first candle acts after the breakout and after that take your trade.