How to Trade with an RSI Indicator

July 20, 2021 04:31 UTC
Reading time: 15 minutes

The Relative Strength Index (RSI) for day trading and intraday trading is a popular tool. If you don't know how to use it yet, you're in the right place. This article will highlight what makes this indicator special, including what it does, how to calculate it and what traders use it for.

We'll also discuss topics such as RSI trendlines and how to trade using the RSI with some strategies like the RSI Two Period Divergence and more. We'll then help you find other indicators to pair with the RSI indicator to enhance your trading.

 

RSI Indicator and Technical Analysis - What is Technical Analysis?

Before we start discussing the best strategies and settings for using the RSI indicator for day trading and intraday trading, we should discuss some basics. Technical analysis is a method of predicting price movements and future market trends, by studying charts of past market action, and comparing them with current ones. Technical analysis is concerned with what has actually happened in the market, and what might happen. It takes into account the price of instruments, and creates charts from that data to use as the primary tool.

One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments simultaneously. There are three main principles in technical analysis that should be covered before taking a precise look at the RSI indicator:

Trend is your friend

Technical analysis is used to identify patterns of market behaviour that have long been recognised as significant. For many given patterns, there is a high probability that they may produce the expected results. Additionally, there are also recognised patterns that repeat themselves consistently.

History repeats itself

Forex chart patterns have been recognised and categorised for over 100 years, and the manner in which many patterns are repeated leads to the conclusion that human psychology has changed little over time.

Price Action discounts everything

This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and market sentiment. However, pure technical analysts are only concerned with price movements, and not with the reasons for any changes that may occur.

One of the indicators that technical analysis is very reliant on is RSI – the Relative Strength Index Indicator. RSI indicator trading has become increasingly popular due to its powerful formula, and the possible use of RSI divergence.

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RSI Indicator - Fundamentals

What is the RSI indicator?

The RSI measures the ratio of up-moves to down-moves, and normalises the calculation so that the index is expressed in a range of 0-100. It was originally developed by J.Welles Wilder. If the RSI is 70 or greater, the instrument is assumed to be overbought (a situation whereby prices have risen more than market expectations). An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation in which prices have fallen more than the market expectations). With this information, we can use the RSI indicator for day trading to our advantage.

Contrary to popular opinion, the RSI is a leading indicator. The formula for the RSI indicator takes two equations that are involved in solving the RSI formula. The first component equation obtains the initial Relative Strength (RS) value, which is the ratio of the average 'Up'' closes to the average of 'Down' closes over 'N' periods represented in the following RSI formula example:

  • RS = Average of 'N' day's closes up / Average of 'N' day's closes down

The actual RSI value is calculated by indexing the indicator to 100, through the use of the following RSI formula example:

  • RSI = 100 - (100 /1 + RS)

If you are using MetaTrader (MT4), you can attach the indicator on your MT4 chart, and simply drag and drop it to the main chart window. The GIF provided below demonstrates this process:

Source: MetaTrader 4 - RSI Indicator selection

 

Let's look at how to use the RSI to trade. In the next section, we will explain how to use the RSI indicator for day trading and intraday trading.

How to Use the RSI Indicator for Day Trading - Best RSI Indicator Setting for a Day Trading Strategy

We will now discuss how to use the RSI indicator for Day Trading. For many traders, using the RSI indicator in a day trading strategy is very beneficial. The default RSI setting of 14 periods is suitable for most traders, especially for swing traders.

But some intraday traders use different settings when using the RSI indicator for day trading. They don't like using the 14 setting, because they find that it generates infrequent trading signals. As a result, some traders choose to lower their time frame, while others opt for setting the RSI period a bit lower to increase the sensitivity of the oscillator. Some traders deal with this problem by lowering their time-frame. Others lower the RSI period setting to get a more sensitive oscillator.

In general:

  • Short-term intraday traders (day trading) often use lower settings with periods in the range of 9-11.
  • Medium-term swing traders frequently use the default period setting of 14.
  • Longer-term position traders often set it at a higher period, in the range of 20-30.

Which settings to choose when using the RSI indicator for day trading depends on your strategy.

RSI Indicator Setting for an Intraday Trading Strategy

Pick the most effective settings for your specific trading style by determining how much noise you are willing to process with the data you receive. Remember that regardless of the setting you choose, as you gain experience with this indicator, you will become better at recognizing reliable signals.

In the case of using the RSI indicator for day trading and intraday trading, you will be making short-term trades. Here, traders often choose lower settings for all of the variables as this provides earlier signals in this highly competitive environment. As we mentioned above, short-term intraday traders usually use lower settings with periods ranging from 9-11.

RSI Indicator Trading Strategies

You are now an RSI indicator pro. But you need to know how to use the RSI indicator effectively. It's time to look at how to trade with the RSI. Here are some examples of RSI indicator settings to use in different trading strategies:

RSI OBOS Levels

This can be considered an RSI trendline strategy because it aims to predict when the price will bounce off the trendline, which is an opportunity to enter a trade. If the RSI is less than 30, it means that the market is oversold, and that the price might eventually increase. Once the reversal is confirmed, a buy trade can be placed. Conversely, if the RSI is more than 70, it means that it's overbought, and that the price might soon decline. After a confirmation of the reversal, a sell trade can be placed. The RSI 50 level is the midline that separates the upper (Bullish) and lower (Bearish) territories. In an uptrend, you will usually see the RSI above 50, while in a downtrend, it is below the RSI 50 level.

Depicted: Example of MetaTrader 4 - Mini Terminal - EURUSD - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

RSI Two Period Divergence

This strategy is sometimes referred to as an RSI 14 trading strategy. Apply a short 5 period RSI (RSI 5) over the longer (default) 14 period RSI (RSI 14) and watch for crossovers. With the RSI 14 trading strategy, there are times when the market does not reach the oversold or overbought levels before a shifting direction occurs. A shorter period RSI is more reactive to recent price changes, so it can show early signs of reversals. When the RSI 5 crosses above the RSI 14, it means that recent prices are getting higher.

A buy signal is then generated, and a 5 vs. 14 cross should happen when the 5 period (blue) is oversold (below 30). When the RSI 5 crosses below and becomes lower than the RSI 14, it means that recent prices are declining. This is a sell signal. A 5 vs. 14 cross should occur when the 5 period (blue) is overbought (above 80). Experienced traders may find that their trading performance greatly benefits from combining an RSI trading strategy with Pivot Points.

Depicted: Example of MetaTrader 4 - EURUSD - ECN Hourly Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

RSI Trendlines

Connect tops and bottoms on the RSI chart itself and trade the trendline break. To draw an RSI uptrend line, connect three or more points on the RSI line as it rises. A down trendline is drawn by connecting three or more points on the RSI line as it falls. The break of an RSI trendline might indicate a potential price continuation or a reversal. Bear in mind that the break of an RSI trendline usually precedes the break of a trendline on the price chart, thus providing an advance warning, and a very early opportunity to trade.

Depicted: Example of MetaTrader 4 - EURUSD - ECN Hourly Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

RSI Classic Divergence

RSI bearish divergence forms when the price forms a higher high, and at the same time the RSI decreases, and forms a lower high. You will usually see RSI divergence forming at the top of the bullish market, and this is known as a reversal pattern. Traders expect the reversal when the RSI Divergence forms. It is an advance reversal warning, as it appears in several candlesticks before the uptrend changes its direction, and breaks below its support line.

Conversely, the RSI bullish divergence will form when the price forms a lower low, and the RSI forms a higher low. This is a warning sign that the trend direction might change from a downtrend to an uptrend. RSI divergence is widely used in Forex technical analysis. Some traders prefer to use higher time-frames (H4, Daily) for trading RSI divergence. Using these strategies, you can achieve various RSI indicator buy and sell signals.

Depicted: Example of MetaTrader 4 - EURUSD - ECN Daily Chart - Disclaimer: Charts for financial instruments in this article are for illustrative purposes and does not constitute trading advice or a solicitation to buy or sell any financial instrument provided by Admiral Markets (CFDs, ETFs, Shares). Past performance is not necessarily an indication of future performance.

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Which indicator works best with RSI?

Along with strategy and settings, we can combine other technical indicators to complement the RSI when using the RSI indicator for intraday trading and day trading. Some of the best ones are momentum indicators. We recommend using the moving average convergence divergence (MACD) and moving average crossovers.

The RSI can maintain overbought readings for quite some time, while the MACD can show divergence by turning down as the price advances, further indicating that the market is overextended and may retrace.

Exponential Moving Averages can help confirm RSI indications. For example, the EMA 5 crossing over the EMA 10 compliments the RSI indicator very effectively.

Conclusion: RSI Forex Trading

It is so easy to jump and start using the Forex RSI indicator for day trading, that novice traders often begin without testing different parameters, or educating themselves on the proper interpretation of an indicator, because of the desire to grab money quickly! As a result, the RSI has become one of the most widely misused MT4 indicators.

Once understood and correctly applied, using the RSI indicator for day trading will help you develop the ability to indicate whether prices are trending, when a market is overbought or oversold, and the best price to enter or exit a trade.

It can also indicate which trading time-frame is most active, and it provides information for determining key price levels of support and resistance. The RSI can provide you with technical trend information, as well as RSI buy and sell signals. It is crucial that you practise RSI trading strategies on a demo account first, and then apply them to a live account. Additionally, the RSI strategies can complement any Forex trading strategy that you may have already been using.

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of, or recommendation for, any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks. 

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