Trading strategy using the Relative Strenght Index (RSI)
The Relative Strength Index - RSI is a momentum indicator that measures the magnitude of recent price changes to analyze overbought or oversold conditions. It is primarily used to attempt to identify overbought or oversold conditions in the trading of an asset.
The relative strength index (RSI) is calculated using the following formula:
RSI = 100 - 100 / (1 + RS)
Where RS = Average gain of up periods during the specified time frame / Average loss of down periods during the specified time frame. The RSI provides a relative evaluation of the strength of a security's recent price performance, thus making it a momentum indicator. RSI values range from 0 to 100. The default time frame for comparing up periods to down periods is 14, as in 14 trading days. Traditional interpretation and usage of the RSI is that RSI values of 70 or above indicate that a security is becoming overbought or overvalued, and therefore, may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below is commonly interpreted as indicating an oversold or undervalued condition that may signal a trend change or corrective price reversal to the upside.
Sudden large price movements can create false buy or sell signals in the RSI. It is, therefore, best used with refinements to its application or in conjunction with other, confirming technical indicators.
Some traders, in an attempt to avoid false signals from the RSI, use more extreme RSI values as buy or sell signals, such as RSI readings above 80 to indicate overbought conditions and RSI readings below 20 to indicate oversold conditions. The RSI is often used in conjunction with trendlines, as trendline support or resistance often coincides with support or resistance levels in the RSI reading.
In the example here we can observe the EUR/USD on the 1-hour time frame.
The RSI indicator has been applied to the chart with the parameters of 11 as period, not 14 and with highlighted levels of the overbought 70 and oversold 30. I have marked the areas on the indicator where the security or the instrument is in the relevant situations. As well of that I have distinguished 6 situations capturing past moments and a recent one with a buying signal in the middle of Friday's market activity.
As we can see in situation 1 we have a buying signal on the 09.10 with and we can take a long position in the pair until the next signal, which is a sell one on 10.10 (the next day). There we can close the position and open a short one with the next candle. That's 100 pips profit. In situation 2 we have the sell signal, but probably it will hit our stop loss as the price continues to move up. On situation 3 we have another sell signal where we will return our losses for sure and we can close nicely on situation 4 where we can buy because of the buy signal on 18.10, but unfortunately with another stop loss.
Watching for a divergence between price and the RSI indicator is another means of refining its application. Divergence occurs when a security makes a new high or low in price but the RSI does not make a corresponding new high or low value. Bearish divergence, when price makes a new high but the RSI does not, is taken as a sell signal. Bullish divergence, which is interpreted as a buy signal, occurs when price makes a new low, but the RSI value does not.
In situation 5 we have a bearish divergence where with a sell signal from RSI as it comes above from level 70 gives us a second signal and a confirmation that the price indeed will fall down hard. On the next candle, we can sell with an appropriate stop loss. Situation 6 is from Friday. We have a buy signal and a bullish divergence as well. Buying on the next candle would have left us with +80 pips floating equity and if we are satisfied we can close it there on the opening on Monday or wait for a sell signal.
RSI can be a profitable indicator, but it is not recommended to use it only alone. Try combining the indicator with moving averages, trend lines or other indicators to find more confirmations and to be more aware of the signal that is provided from RSI won't be a fake one, because the price is actually on the bottom or top lines of a trend or on a major support or resistance. And as always, test it on demo first before going live with it.