Relative strength index trading strategies

The RSI indicator can provide a number of different trading signals. This article highlights three methods of using the RSI alongside price action, to provide a trading strategy. 

Data
Source: Bloomberg

What is the relative strength index indicator?

The relative strength index (RSI) indicator is one of the most popular tools for new traders, with the momentum indicator finding prominence amongst both novice and advanced traders, since its developments by J Welles Wilder.

Part of its attraction is the simplicity of it, with the overbought/oversold parameters providing clear buy and sell signals. However, there are a number of techniques traders can utilise, in a bid to make the tool more profitable. 

Strategies for trading with the relative strength index

Overbought/oversold

The standard method for using the RSI is similar to many of the other range-bound momentum indicators, utilising overbought and oversold conditions. Traders will typically see a market as being overbought above 70, yet oversold below 30. That being said, there are a great deal of idiosyncrasies associated with using this tool.

A range-bound market may utilise the traditional overbought/oversold levels perfectly well, given the neutral tone of the market. However, it makes sense that a downtrend would stay in oversold territory for longer, while it may never hit the overbought reading of 70. With that in mind, it makes sense to look for new levels as thresholds in different scenarios.

On the example below, it is clear that the upwardly trending market is driving a number of overbought conditions, yet few oversold ones. Firstly, it is worth noting that the sell signals provided by an overbought reading are typically more powerful when seeing the RSI fall back below 70 (green dashed lines), rather than their initial break into overbought (red dashed lines). 

Secondly, it is advisable to try to trade with the trend where possible, and given there are a lack of oversold signals, we need to adjust the parameters to account for the market bias. Shifting the oversold territory to 35 (based on the prior two retracements), it is clear that we are now in a position where this market could turn higher once again. This bullish bias is confirmed by the existence of Fibonacci support.

RSI divergence

A divergence occurs when momentum fails to follow price action in the creation of peaks and troughs. For an uptrend, you want to see the RSI create new higher highs, alongside price action. When momentum creates lower highs, while the price forms higher highs, it is a sign that the market could be about to turn.

The example below shows it in action, with EUR/GBP first seeing a bullish divergence, followed swiftly by a bearish divergence. The creation of a new low in late September came alongside a higher low on the RSI. This was followed by bearish divergence, where the RSI failed to follow the higher highs being set by the price, with said price subsequently following it lower.

It is important to always await a signal in price action to confirm the potential reversal highlighted by a RSI divergence. On this occasion, the trendline break provided a supplementary reversal signal.

Failure swings and RSI formations

The failure to create a new higher high (uptrend), or lower low (downtrend) in the RSI is called a failure swing. These failure swings can be utilised across a number of methods, with standard technical analysis patterns coming into use. This means patterns such as head and shoulders, double tops, wedges and the like can be utilised as potential reversal signals.

The USD/CAD chart below highlights a market reversal, with the double top formation on the RSI paving the way for a turn in price action. Once again, utilising price action alongside the RSI would have provided higher degree of accuracy, selling on the break below $1.3816. However, on this occasion, we see that it would have given a delayed signal. 

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