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The RSI indicator – Trade the “Zone”

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The use of RSI in the ” Price Zones” analysis method

The “Relative Strength Index”, or RSI, is one of the most commonly used indicators in the technical analysis world.

Unlike modern sophisticated indicators, the RSI indicator is a very simple indicator that can used to find potential trend exhaustion scenarios by providing oversold and overbought indications. These oversold and overbought zones are used by many technical traders to try and time shifts in trend (in order to protect profits or trade the reversal).

There are a lot of very good articles about the RSI indicator. If you are not familiar at all with the RSI indicator, you can find some useful information in these sites: www.Stockchart.com or  Investopedia.com

The purpose of this article is to demonstrate the use of the RSI indicator in the”Price Zone” trading method.

RSI indicator

source: www.wikipedia.org

Basic RSI concepts:

As mentioned above, the purpose of the RSI  indicator is basically to provide indication whether a specific underline (financial asset) in oversold or overbought conditions.

The RSI includes two extreme zones (overbought/oversold) that their threshold levels usually change between the default levels, which are set for 30/70 in most charting\trading platforms, and extreme levels of 20/80 that some use to find more accurate signals (reducing the level of false signals).

Like any other indicator, the RSI results changes according to the time frame in which it is measured – You can look at a stock, for example, that is overbought at the hourly chart but deeply oversold at the weekly chart. The way you use this information is totally depending on your trading style and trading strategy, but wrong use of this info can also make the difference between success and failure.

The overbought/oversold indication can be used as technical consideration before taking a trade (part of your trading rules for example), or it can be used as a warning signal for existing trades (also should be defined as part of your trading strategy). For example, if someone holds a long position on $EURUSD which was based on a daily analysis, he/she perhaps should consider taking profits once the price reaches the overbought zone on a daily time frame (Note – This approach should be tested and confirmed as successful over time via back testing of course).

The RSI’s information can also help you determine the time frame in which you will allow you trades to work. For example – If someone buys an overbought stock (daily time frame) based on a technical pattern that he/she found on the hourly chart, he/she might consider to consider this trade as a short term trade (day trading or scalping) with small risk and short term targets to avoid the risk of going long at a potential daily bearish reversal zone. On the other hand, if you are buying an oversold stock and you have a technical setup that supports major price reversal, you may want to consider keeping this trade for a little longer and let it work as a swing trade with multiple targets levels (short term and longer term) that you will hold for days/weeks.

Here are some examples for trading rules, that are common for the RSI indicator:

Risk management rules:

Not buying at overbought territory

Not selling at oversold territory

No trades taken in the mid-area

Trade management rules:

Not exiting a trade before it reaches extreme zone (overbought/oversold)

Exit trades as they reach extremes

Look to buy at oversold territory

Look to sell at overbought territory

*These are very simple and basic rules that probably won’t generate consistent profits overtime but can be used as part of a bigger trading strategy. 

The RSI’s parameter can be set to generate different signals – Some use a shorter or longer time period that to generate more or less frequent signals (instead of the default 14 period number) and some use different threshold levels (as explained before) for the same purpose. Like any other indicator, these changes should be tested and should eventually provide better edge for the users (traders).

Besides the parameters changes, there are also different approaches of how to use the Indicator’s signals – Some traders trade when the price is at the extreme zone and some prefer to wait for the RSI line to cross below/above the overbought/oversold threshold lines. It all depends on the trader’s experience and the trading system he tested to be successful.

RSI in the “Zone” – RSI with harmonic trading patterns

In the “Price Zones” analysis method I often use the standard RSI with default settings and rarely an adjusted RSI with some tweaks to know whether the chart I’m looking at is at highly extreme overbought\oversold conditions. I never use the RSI signals to trigger my entries, but they have their weight and they are part of my technical considerations before I take any new trade.

The “Zones” system is all about maximizing my statistical trading edge before I take a trade. The RSI extremes give me additional statistical edge that I add to other parameters such as patterns strength, structure zones and trend when I’m making my analysis and preparing my trading plans.

As you can see in the Weekly Markets Analysis newsletter, most of the harmonic trading patterns and trading scenarios that I’m posting come with overbought/oversold conditions or with RSI divergences (read more below)

Usually you will see that the X point of a harmonic trading pattern appears at an extreme RSI zone and by the time that the pattern reaches the PRZ, the RSI is again either in extreme zone again or near it and creating a divergence.

Combining harmonic trading pattern with RSI extreme is one example for the kind of statistical trading edge I’m looking for before placing a new trade. The same goes for classical technical analysis patterns or Price Action pattern.

Let me demonstrate it with few examples:

Harmonic trading pattern with RSI

The pattern seen below, posted in the Weekly Markets Analysis newsletter and in the MarketZone blog, is a perfect example of what I’ve wrote above. In the chart you can see how the X point starts with RSI at oversold territory (buying opportunity for itself) and how the harmonic trading pattern completes at oversold again – Creating a perfect “Zone” entry.

This pattern and this setup completed few days before $YUM earnings report and you can see the results of this setup with your own eyes.

RSI and harmonic trading

The perfect “Price Zone” – When everything comes together in perfect harmony

RSI and harmonic trading

The bearish Price Zone that you see above is one of the first trading scenarios that I sent to the Elite Zone members shortly after I launched the service.

The first thing I noticed was the upward spike that created the first false break to the trading channel that you can see above at $GBPUSD chart. As you can see at the lower part of the chart, the RSI was extremely overbought conditions when GBPUSD spiked above the trading channel for the first time.

The second false breakout attempt completed an harmonic trading pattern (a bearish Butterfly pattern) and also created a bearish divergence in the RSI indicator

*Bearish divergence = Higher highs in price action and lower highs in momentum (RSI)

If you are looking for a statistical edge – That one was as good as it gets!

  • Here are the technical elements that supported the bearish reversal scenario:
  • RSI overbought with bearish divergence
  • Top of trading channel
  • Second false break
  • Harmonic trading pattern (bearish)
  • Price action reversal pattern (Outside bar)

As you can see, this bearish setup led to a 300 pips decline in GBPUSD price.

 

Price Action reversal pattern with RSI extremes

RSI and Price Action

The previous example showed the kind of reversal that a combination of harmonic trading pattern, classic trading channel and RSI at overbought can generate.

This example (the chart above) is a relatively new trading idea that I’ve found and shared with the members (you can see that the reversal just occurred recently and the move has just started).

$ACI chart shows that the price formed several Price Action reversal patterns patterns and also daily false break signal with RSI at overbought conditions. The price showed immediate reaction to my bearish scenario and experienced a small sell off…

This trading scenario was sent to the Elite Zone members before the reversal actually took place. One can consider the breakdown of the daily uptrend line (that followed the stock from 4.10$ to 5.10$) as bearish confirmation signal  that may lead to a wider and deeper daily correction move.

Summary:

Despite being one of the oldest and simplest indicators, the RSI is a great trading tool that can provide real trading edge.

It is easy to use, easy to understand and it is a great tool for newbies. As I showed above, the RSI extreme zones can help you determine the direction that you want to be trading with and also assist you with the timing of your trade.

The RSI is a lagging indicator and it works differently in a trending environment or a non-trending one (consolidation mode).

This article wasn’t made to thoroughly explore all of the RSI abilities. You can read much more on RSI and its use in other sources on the net. The purpose of this article was to reveal some of its power and to demonstrate how I use it as part of the “Price Zones” method.


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