Using the RSI correctly
In this article, we will cover one of the most popular oscillators – the relative strength index (RSI). You have probably read a number of general articles on the RSI; however, in this post I will present four trading strategies you can use when day trading.Before we dive into the strategies, let’s first ground ourselves on the RSI indicator.
Relative Strength Index Definition
The Relative Strength Index (RSI) is one of the most popular indicators in the market. If you look over any market technician's shoulder there are a few indicators that show up quite frequently: MACD, simple moving average, volume and last but not least the RSI. The RSI is a basic measure of how well a stock is performing against itself by comparing the strength of the up days versus the down days. This number is computed and has a range between 0 and 100. A reading above 70 is considered bullish, while a reading below 30 is an indication of bearishness.Relative Strength Index Formula
The RSI was developed by J.Welles Wilder and detailed in his book New Concepts in Technical Trading Systems in June of 1978. For all you hardcore technicians, below is the relative strength index formula:The default setting for the RSI is 14 days, so you would calculate the relative strength index formula as follows:Relative Strength =
1.25 (Avg. Gain over last 13 bars) +. 25 (Current Gain) / (.75 (Avg. Loss over last 13 bars) + 0 (Current Loss))
Relative Strength = 1.50 / .75 = 2
RSI = 100 - [100/(1+2)] = 66.67
Now that we know the relative strength index formula, let's analyze how to actually use this powerful indicator. Most traders use the relative strength index simply by buying a stock when the indicator hits 30 and selling when the indicator hits 70. If you remember anything from this article, remember that if you buy and sell based on this strategy "YOU WILL LOSE MONEY". The market does not reward anyone for trading the obvious. Now that doesn't mean that simple methods don't work, but simple methods that everyone else is following have really low odds.
Psychology Behind the Relative Strength Index Double Bottom Signal
The first price bottom is made on heavy volume, which occurs after the stock has been in a strong uptrend for some period of time. This is the reason as mentioned below, that the RSI has been above 30 for a considerable amount of time. After the first price sell off, which also results in a breach of 30 on the RSI, the stock will have a snap back rally. This rally is short lived and is then followed by another snap back reaction which breaks the low of the first bottom. This second low is where stops are run from the first reaction low. Shortly after breaking the low by a few ticks, the stock begins to rally sharply. This second low not only forms a double bottom on the price chart, but the relative strength index as well. The reason this second rally has legs is for (1) the weak longs were stopped out of their position on the second reaction, and (2) the new shorts are being squeezed out of their position. The combination of these two forces produces sharp rallies in a very short time frame.Using the RSI correctly
Many users of the RSI incorrectly assume that you should buy stocks with the highest relative strength. This key to using the relative strength index formula is to find stocks that are just breaking out of a sideways range with relative strength compared to the indices. The time to sell a stock is when the stock has advanced significantly out of that base with an overbought RSI reading.Day Trading with the Relative Strength Index
The key components you want to see in a valid RSI bottom are the following:- Double bottom (RSI hits at or below 30 twice within 1 hour of each bottom)
- High volume on first price bottom
- The first bottom on the relative strength index is the first touch of 30 or less on the RSI in the last 39 bars (represents half a trading day on 5-minute chart...feel free to change the bar interval to reflect your trading time frame)
Relative Strength Stop Placement
With all trades you must use proper risk management, so stops are crucial. You will want to put your stop about .2 -.4% below the second bottom of this formation. In theory, if the squeeze has begun, the stock has no business breaching the second bottom's low.RSI Profit Targets
Traders should keep a close eye on time & sales to see when the tape begins slowing down, to exit either half or all of the position. Remember, the reaction off of a RSI double bottom is sharp and fast.Trading Strategies Using the RSI Indicator
Although the RSI is an effective tool, it is always better to combine the RSI with other technical indicators to validate trading decisions. The strategies we will cover in the next section of this article will show you how to reduce the number of false signals so prevalent in the market.#1 - RSI + MACD
In this trading strategy, we will combine the RSI indicator with the very popular MACD. We will enter the market whenever we receive an overbought or oversold signal from the RSI supported by the MACD. We will close our position if either indicator provides an exit signal.
RSI+ MACD
A bit more than an hour after the morning open, we notice the relative strength index leaving an oversold condition, which is a clear buy signal. The next period, we see the MACD perform a bullish crossover – our second signal.
Since we have two matching signals from the indicators, we go long with IBM. We appear to be in the beginning of a steady bullish trend. Five hours later, we see the RSI entering oversold territory just for a moment. Since our strategy only needs one sell signal, we close the trade based on the RSI oversold reading.
This position generated $2.08 profit per share for approximately 6 hours of work.
#2 - RSI + MA Cross
In this trading strategy, we will match the RSI with the moving average cross indicator. For the moving averages, we will use the 4-period and 13-period MAs.We will buy or sell the stock when we match an RSI overbought or oversold signal with a supportive crossover of the moving averages. We will hold the position until we get the opposite signal from one of the two indicators or a divergence on the chart.
In addition, I want to clarify something about the MA cross exit signals. A regular crossover from the moving average is not enough in order to exit a trade. I recommend waiting for a candle to close beyond both lines of the moving average cross before exiting the market. To illustrate this trading strategy, please have a look at the chart below:
RSI + MA Cross
RSI enters the oversold area with the bearish gap the morning of Aug 12. Two hours later, the RSI line exits the oversold territory generating a buy signal. An hour and a half later, the MA has a bullish cross, giving us a second long signal. We buy McDonalds as a result of two matching signals between the RSI and the MA Cross. McDonald’s then enters a strong bullish trend and 4 hours later, the RSI enters the overbought zone.
At the end of the trading day, we spot a bearish divergence between the RSI and McDonald’s price. Furthermore, this happens in the overbought area of the RSI. This is a very strong exit signal and we immediately close our long trade.
This is a clear example how we can attain an extra signal from the RSI by using divergence as an exit signal. This long position with MCD made us a profit of $2.05 per share.
#3 - RSI + RVI
Now I will show you how to combine the relative strength index with the relative vigor index. In this setup, I will enter the market only when I have matching signals from both indicators. I will hold the position until I get an opposite signal from one of the tools – pretty straightforward.
RSI + RVI
First, we get an overbought signal from the RSI. Then the RSI line breaks to the downside, giving us the first short signal. Two periods later, the RVI lines have a bearish cross. This is the second bearish signal we need and we short Facebook, at which point the stock begins to drop.
After a slight counter move, the RVI lines have a bullish cross, which is highlighted in the second red circle and we close our short position. This trade generated a profit of 77 cents per share for a little over 2 hours of work.
Facebook then starts a new bearish move slightly after 2 pm on the 21st. Unfortunately, the two indicators are not saying the same thing, so we stay out of the market.
Later on, the RSI enters oversold territory. A few periods later, the RSI generates a bullish signal.
After two periods, the RVI lines also have a bullish cross, which is our second signal and we take a long position in Facebook. Just an hour later, the price starts to trend upwards. Notice that during the price increase, the RVI lines attempt a bearish crossover, which is represented with the two blue dots.
Fortunately, these attempts are unsuccessful and we stay with our long trade. Later on, the RVI finally has a bearish cross and we close our trade. This long position with FB accumulated $2.01 per share for 4 hours.
In total, the RSI + RVI strategy on Facebook generated $2.78 per share.
#4 - RSI + Price Action Trading
This is a setup, which should always be taken into consideration. Some traders don’t like overloaded charts and this trading setup might suit them well. Here I will use the RSI overbought and oversold signal in combination with any price action indication, such as: candle patterns, chart patterns, trend lines, channels, etc.In order to enter a trade, I will need an RSI signal plus a price action signal – candle pattern, chart pattern or breakout. I will hold every trade until I get a contrary RSI signal, or I get a price action indication that the stock move is ending.
RSI + Price Action Trading
The chart image starts with the RSI in overbought territory. After an uptrend, the BAC chart draws the famous three inside down candle pattern, which has a strong bearish potential. With the confirmation of the pattern, we see the RSI also breaking down through the overbought area.
We match two bearish signals and we short the BAC stock. The price starts a slight increase afterwards. This puts us into a situation, where we wonder if we should close the trade or not. Fortunately, we spot a hanging man candle, which has a bearish context.
We hold our trade and the price drops again. Look at the three blue dots on the image. These simple dots are enough to build our downtrend line. After we entered the market on an RSI signal and a candle pattern, we now have an established bearish trend to follow!
The trend resists the price (yellow circle) and we see another drop in our favor. Later on after this decrease, BAC breaks the bearish trend, which gives us an exit signal. We close our position with BAC and we collect our profit. This trade made us 20 cents per share.
Which RSI Trading Strategy?
I really believe that the RSI goes well with the RVI. In the RVI and relative strength index formula example, I find harmony between the two indicators and the way they smooth out the price action.Furthermore, the RVI gives clear indication when the market is trending.
Conclusion
- The RSI is a momentum indicator.
- RSI fluctuates between 0 and 100 providing overbought and oversold signals.
- Readings above 70 are considered bullish.
- Readings below 30 are considered bearish.
- The default RSI formula is calculated based on:
- Gains over the last 13 periods
- Current gain
- Average loss over the last 13 periods
- Current loss
- Stop loss orders are recommended when trading with the RSI.
- RSI should be combined with other trading tools for better signal interpretation.
- Some of the successful RSI trading strategies are:
- RSI + MACD
- RSI + MA Cross
- RSI + RVI
- RSI + Price Action
- RSI + RVI are the better team when trading intraday.
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