Hello there, this is tradingpedia.com and this video deals with the Relative Strength Index (RSI), one of the most important, if not the most important oscillators, a technical analysis tool used in retail trading. All investors have looked at one point in time at the RSI because its power is undeniable and works well both in trading and ranging markets.
What Is the Relative Strength Index
The RSI is an oscillator and if you use the MetaTrader platform like this one here, you can insert it on any timeframe. You can find it under the Insert, Indicators, then we go to Oscillators, and this is the RSI. By default, it comes with a period of 14, meaning that the current value that the RSI shows refers to the last 14 candlesticks. This being the 4h chart, it means that the 14 periods refer to the last 14 four-hour periods. If you apply it on the daily chart, it will consider the last 14 days, and so on.
The RSI has two levels – 30 and 70. 70 is considered overbought, and 30 oversold. If you apply it on any chart, it will appear on a small window below the main price. The main idea with the RSI is to buy oversold levels, meaning every time it goes below the 30 is oversold, and we should buy. For instance, here you go on the long side, almost picking the bottom, and the same even here. Why? Because the RSI keeps coming to the oversold territory.
The opposite happens when the market reaches overbought territory – above the 70 level. Here we should go short when the market prints above 70. However, there is a catch, as trading is not that simple nor easy.
This strategy works very well if the market is in consolidation. As you can see, the EURGBP pair does not go anywhere since May 2020 and we see a horizontal consolidation around 0.90.
How about in a trending market? If that is the case, the RSI may remain overbought or oversold for quite some time. Therefore, this strategy works very well when you expect ranging markets. For instance, summer trading. It is known that during July and August prices consolidate more. Holidays, like Christmas, are also characterized by little or no trading activity.
Cross pairs, the ones that do not have the USD in their componence, consolidate more than major pairs. Also, think of lower timeframes, and trading crosses during illiquid sessions like the Asian sessions, known as slower price action like the Northern American session. So this is one way to trade with the RSI.
Look For Divergences
Another way to trade with the RSI is to look for divergences, and this one applies to any other oscillator that has overbought and oversold levels. A divergence refers to the market making two consecutive lower lows and the oscillator fails to confirm the second lower low. Or the market forms two consecutive higher highs and the oscillator fails to confirm the second higher high. So, why should we trust the oscillator?
Remember, the RSI considers 14 candlesticks. So, this value here is based on the closing price of the previous 14 candlesticks. Therefore, if we are to consider that one of these two lines is giving false information, that would be the price, and not the oscillator. Therefore, in a bullish divergence you look for the market to form a series of two consecutive lower lows, while at the same time the RSI will not confirm the second one. This is why it is called a divergence, because here you have two lower lows and the two lower lows and the trendline has a falling angle, while this one has a rising angle because the second lower low is not confirmed by the RSI. Of course, after a divergence, the market bounces, and this is where the trade comes into place.
Bullish and Bearish Divergence
As always, for any trade you must have a stop loss. The market may remain in a divergent mode more than the trade can remain solvent. If you want to wait for a market confirmation, this would be the bounce, and then going on the long side here with a stop-loss at the lows and targeting 1:2 risk-reward ratio would be appropriate for trading a divergence. This is called a bullish divergence.
But there is also a bearish divergence, based on the same principle. The market forms two higher highs, while the RSI fails to confirm those highs. Here, as you can see, it is a double bearish divergence.
Bearish divergence, bullish divergence – one calls for going short, the other one for going long. One more thing before we are done with the RSI – you can alter the RSI periods in any way you want.
For instance, the 14 period is the default number of periods considered when the RSI was first used and developed. But you can change it and set the RSI to use more or fewer periods. The more periods it will consider, the flatter the line will become, and the more difficult it would be for it to reach the overbought and oversold areas. So if you want to filter the signals when trading with the overbought and oversold trading strategy, you may want to increase the number of periods to make it more difficult for the RSI to reach overbought or oversold and then by the time it will reach it you will go a bit more aggressive, as you will have more confidence on that trade. The same remains valid for bullish and bearish divergences.
Thank you for being here – bye bye.