RSI indicator trading strategy – 5 systems

and the back test results!

 

Digging into the quintessential overbought oversold indicator!

rsi indicator

The RSI indicator is a cruel mistress!

She lure’s us in with promises of easy money and trading success,

only to drain your trading account balance in a run of terrible stoploss strikes, Even thought the indicator said BUY!

The fact is;

Oscillator indicators in general, are risky and unreliable beasts.

They might look friendly and approachable at first, only to BITE your hand off just when you are most comfortable!

The RSI indicator is usually the go to oscillator for the novice trader when deciding to enter that first trade.

There is a simple, valid reason for this;

The RSI indicator is simple to read and understand

and it “APPEARS” to get great results when given the visual back-test!

( Come on, admit it, we have all done it! We take a quick glance at the RSI indicator in search of that sweet confirmation bias when we are just itching to make a trade. )

It is almost impossible to resist the siren call of a trading signal from our favorite indicator.

But approaching trading in a passive fashion like this is dangerous and will lead to the destruction of your account eventually!

In this article I will teach you how to avoid some of the major pitfalls that beset most beginner traders when it comes to the RSI indicator.

I am going to show you a few important things:

  • I am going to break down the RSI indicator so you understand it from head to toe.
  • I will explain the top 5 RSI trading strategies that we hear so much about, what they mean and how to trade using them.
  • I will back test each of those strategies against the EURCHF over a 16 month period and see how they actually performed, using a sample starting account of $1000, and a sensible stoploss strategy.

After reading this article you will Know the RSI indicator inside out,

AND;

YOU WILL BE better informed on the risks of using each of the RSI trading strategies to generate trading signals,

So;

the next time the siren calls, you will think twice about placing that trade!

 

relative strength index calculation

 

These are the nitty gritty details on how the RSI indicator is built.

In reality your charting software will do this calculation for you, thats what technology is for!

1: Pick the base number of periods on which to base the study.

2: compare todays closing price with yesterdays.

3: add all the upward movements in points between closing prices.

4: add all the downwards movements between closing prices.

5: calculate the EMA ( exponential moving average ) of the upward and downward price movements

6: calculate the relative strength,

RS = EMA Upward Price Movements / EMA Downward Price Move ments

7: Calculate the Relative Strength Index (RSI):

RSI = 1 / ( 1 + RS )

 

RSI definition, what does it all mean for my trading?

 

The RSI indicator Has definitely got one up over its competing oscillator in the fact that it has fixed points extremes at 0 and 100.

Rather than the relative floating extremes of say the Momentum or Rate of change oscillators.

In that sense it does give the trader a base to work from in judging one period of market action to another.

The RSI indicator is also smoother than it’s big brothers, Because it uses the Exponential moving average, it tends to be less jumpy and more consistent.

In general the RSI is interpreted as follows;

If the indicator is below 30, then the price action is considered weak and possibly oversold.

If it is reading above 70, then the asset is after a strong uptrend and could be overbought.

Because the RSI is used as a tool to indicate extremes in price action, then the temptation is to use it to place contrarian trades,

Buying when the indicator crosses 30 to the upside means you are counting on the trend reversing and then profiting from it. The same is true for selling when the RSI crosses down below 70 and using this a sign that the market is reversing from a strong uptrend.

Life is never that simple though, and more often than not, you will find that the risk involved in this type of simplistic approach is ruinous to you account balance.

New traders tend to gravitate to the RSI when attempting to delve into analysis for the first time.

It is easy to aproach and easy to understand, it has fixed overbought and oversold levels and it tends to be correct over longer periods,

So;

I can see why it is so attractive to all of us,

However, you cannott ignore the hugh failings of the RSI indicator in a strong trend!

It can stay at 90 for days on end,

dancing above the overbought line like it is on speed at a london rave in 1992!

This is no good to the novice trader who pressed the sell button without placing a stop!

Some of us (like myself ) can only learn the hard way!

Here are some quick lessons:

Wait for conformation before considering a trade,

The RSI can remain at extreme levels for long periods in a strong trend

SO;

Dont jump right in when you see a reading of 90, first allow the RSI line to fall back below the overbought line to at least give a stoploss level to trade off .

Watch the Centreline for trend confirmtion.

If the RSI line reaches an extreme and then returns to the centreline it is a better indication of a turning point in the trend. Waiting for this to occur can cut out those nasty impulsive trades!

It is common for technical traders to watch the centreline to show shifts in trend,

If the RSI is above 50, then it is considered a bullish uptrend, and if its below 50, then a bearish downtrend is in play.

 

Simple RSI strategy back test:

 

Forex RSI indicator3

 

Over the last year of trading in EUR/CHF there has been:

5 overbought signals.

and

3 oversold signals.

From the conventional viewpoint, this means the trader got 5 sell signals and 3 buy signals.

Lets see how that worked out for him!

April 2015:
the RSI indicator hit the 30 line to indicate an oversold condition
The trader uses this signal as an opportunity to buy the market
this signal led to a 300 point rise without triggering a 50 point stop loss.
that’s a 300 point gain in your account!

July 2015:
the RSI indicator hit the 70 line to indicate an overbought condition.
The trader uses this signal as an opportunity to sell the market.
this signal led to a 150 point rise
the market triggered a 50 point stop loss.
that’s a 50 point loss in your account!

August 2015:
the RSI indicator hit the 70 line to indicate an overbought condition.
The trader uses this signal as an opportunity to sell the market.
this signal led to a 400 point rise in the market!

the market triggered a 50 point stop loss.
that’s a 50 point loss in your account!

January 2016:
the RSI indicator hit the 70 line to indicate an overbought condition.
The trader uses this signal as an opportunity to sell the market.
this signal led to a 150 point rise in the market!
the market triggered a 50 point stop loss.
that’s another 50 point loss in your account!

January 2016:
the RSI indicator hit the 70 line to indicate an overbought condition.
The trader uses this signal as an opportunity to sell the market.
this signal led to a 250 point rise in the market!
the market triggered a 50 point stop loss.
that’s another 50 point loss in your account!

March 2016:
the RSI indicator hit the 30 line to indicate an oversold condition.
The trader uses this signal as an opportunity to buy the market.
this signal led to a 220 point rise without triggering a 50 point stop loss.
that’s a 220 point gain in your account!

May 2016:
the RSI indicator hit the 70 line to indicate an overbought condition.
The trader uses this signal as an opportunity to sell the market.
this signal led to a 130 point rise in the market!
the market triggered a 50 point stop loss.
that’s a 50 point loss in your account!

June 2016:
the RSI indicator hit the 30 line to indicate an oversold condition.
The trader uses this signal as an opportunity to buy the market.
this signal led to a 100 point decline
while triggering a 50 point stop loss.
that’s a 50 point loss in your account!

In total the trader made 220 point gain in their trading account over 8 trades.

This was done with 2 winning trades and 6 loosing trades.

 

 

How to use rsi indicator in forex trading.

 

In order to get real value from the RSI indicator and take advantage of its benefits,

You need to approach it cautiously and interpret it a little deeper.

Here are a few techniques that you can use to cut out a lot of false signals.

Failure swings;

As I mentioned above,

The problem faced by every trader who uses the RSI indicator is that the market may well continue in its trend despite the fact that it hit an extreme reading,

It might even go on to leave that price level behind in the distance depending on the strength of the trend.

For this reason there came about the concept of the failure swing, in order to interpret the index better.

 

failure swings

 

There is both the bearish and bullish failure swing.

A ‘bearish failure swing’ happens when the RSI enters the overbought zone at 70 and then comes back down below the 70 mark again.

In this case, a short position will be entered only after the RSI cuts down through the 70 line from the top.

The ‘bullish failure swing’ occurs when the RSI enters the oversold zone at 30 and then rallies out again and rises above the 30 line again.

The trader uses this rise above the 30 line as a trigger to go long.

 

Divergence:

 

rsi divergence

 

Positive divergence happens when the price of an asset is drifting lower yet the RSI is starting to trend higher.

This could mean that the price is nearing a bottom and will probably turn up soon.

Negative divergence happens the opposite way, the price is driving higher, but the RSI has stalled and is beginning to turn lower.

When this occurs it is likely that the price will stop rising soon after. And then follow the RSI lower.

Trend confirmation:

 

The RSI can be useful as a tool for trend confirmation.

 

rsi trend confirmation

 

In a strong upward trending environment, the RSI rarely falls below 40, and will most always stick to the 50 – 80 range.

The corollary is true for a downtrend.

In this case the range will below the centreline and spike into the lower end of the indicator.

Overbought and oversold indications:

 

the standard settings for an overbought reading is 70 and for oversold it is 30.

this can be changed by the user to suit their own style.

I generally look for the RSI to register several extreme readings in a row before placing any great weight on the signals.

 

Centreline crossing:

 

When the RSI crosses the centreline it is a stronger signal that a trend change has happened than a simple extreme reading above or below the 70-30 lines.

When the indicator crosses the centreline to the upside, it means that the average gains are exceeding the average losses over the period.

The opposite is true for a downside cross.

When a centreline cross happens, it can be a good time to think about trade entry on a fresh pullback in price.

 

RSI trendline breaks:

 

RSI line itself can be interpreted by trendline analysis.

Its a simple trick but it is a useful analysis tool.

 

trend line break

 

For example in an upward trending market,

Draw a line connecting the dips in the RSI line, if the RSI breaks this trendline to the downside it is an early indicator of an impending change.

A break of the RSI trendline often precedes a break of the price trendline on a price chart.

 

Relative strength index trading strategies

 

Compound RSI Strategies:

 

A compound strategy is when you use two indicators together.

It is always advised to balance the signal of one indicator against another, this will help to cut out alot of false signals

There are a few indicators that pair well with the RSI and using them together can proved better trading signals.

  • RSI, candlestick strategy,
  • RSI, MACD strategy,
  • RSI, MA Cross strategy,
  • RSI, Bollinger band strategy,

All of the above trading strategies should always be used with a risk management strategy alongside.

 

RSI, engulfing candlestick strategy:

 

Forex RSI candlestick indicator

 

In this trading strategy,

We combine the RSI indicator along with an engulfing candle stick.

This strategy will generate far less trades so you can afford to extend the stop loss position.

Only enter the market whenever the RSI gives an overbought or oversold signal which is supported by the a bullish or bearish engulfing candle.

Close the position on a solid break of the opposite RSI line.

April 2015:
The RSI indicator hit the 30 line to indicate an oversold condition
The trader uses this signal as an opportunity to buy the market

The trader waits to get an engulfing candle to confirm the signal.

after the engulfing candle occurred, the trader enters at the open of the next days trade.

this signal led to a 550 point rise without triggering a 100 point stop loss.
that’s a 550 point gain in your account!

March 2016:
The RSI indicator hit the 30 line to indicate an oversold condition
The trader uses this signal as an opportunity to buy the market

The trader waits to get an engulfing candle to confirm the signal.

after the engulfing candle occurred, the trader enters at the open of the next days trade.

this signal led to a 175 point rise without triggering a 100 point stop loss.
that’s a total gain of 725 points in your account in two trades!

that’s a solid performance by any ones standard.

 

 

RSI + MACD:

 

Forex RSI macd indicator

 

In this trading strategy,

We combine the RSI indicator with the MACD.

First, enter the market whenever the RSI gives an overbought or oversold signal which is supported by a  MACD signal line crossing.

And then close the position if either indicator provides an exit signal.

April 2015:
The RSI indicator hit the 30 line to indicate an oversold condition
The trader uses this signal as an opportunity to buy the market

The trader waits for a signal line cross to confirm the signal.

after the engulfing candle occurred, the trader enters at the open of the next days trade.

this signal led to a 400 point gain without triggering a 50 point stop loss.

This combination indicator did not generate any further trades in the above time period.

 

RSI + MA Cross:

 

Forex RSI MA cross indicator

 

In this trading strategy,

we combine the RSI with the moving average crossover indicator.

We place a trade when the RSI gives an overbought or oversold signal which is supported by a crossover of the moving averages.

Close the position on an RSI divergence.

Although this trading system came close, it did not generate any signals over the 16 month time period!

I think we can count this one out as a useful trading system.

 

RSI Bollinger band:

 

Forex RSI bollinger bands indicator

 

In this trading strategy,

We combine the RSI indicator along with a Bollinger band squeeze.

First we wait for a Bollinger band squeeze to occur on a daily chart, the squeeze should come to within 150 points or so.

Only enter the market whenever the RSI gives an overbought or oversold failure swing.

which is supported by a tag of the bands in the same direction.

Fro example:

A bullish signal happens when the rsi falls below 30 and then rises above 30 again

Then a daily candle touches the upper Bollinger band.

Close the position on an RSI divergence.

Again this trading system did not give any signal over the time period. We can count out this system also!

 

So there you have it!

Here are the results of the above back tests of the 5 trading systems;

  • Simple RSI strategy = In total this system made 220 point gain over 8 trades, 2 winning trades and 6 loosing trades.
  • RSI, candlestick strategy = In total this system made 725 point gain over 2 trades, 2 winning trades and 0 loosing trades.
  • RSI, MACD strategy = In total this system made 400 point gain over 1 trades, 1 winning trade and 0 loosing trades.
  • RSI, MA Cross strategy = In total, this system made 0 trades and 0 points gained, 
  • RSI, Bollinger band strategy = In total, this system made 0 trades and 0 points gained, 

 

It is plain to see that the best system in this back test is the RSI candlestick strategy. It did not give many trading signals but, when it did, They were fantastic signals.

And think about it;

The average hedge fund makes about 20% a year, with the very real risk of loosing a whole lot! and what does the average savings account return?

The winning strategy above made about 100% ( depending on the $/pip amount / or lot size ) on your initial capital while risking about 10 – 15% on each of the two trades.

That is some good food for thought!

See other Trading Strategies