To The Moon

What Is RSI?

Let's get a little technical, shall we? An RSI trading strategy uses the Relative Strength Indicator which benefits day trading and forex trading greatly. It has default settings of 14 periods and 70/30 levels. 

The RSI setting will affect how frequently the RSI gives overbought and oversold signals as well as divergence signals to buy and sell. The default RSI setting for the RSI indicator is 14-periods. That means the indicator is calculated using the last 14 candles or last 14 bars on the price chart.

Using a shorter timeframe, for example 5-periods will cause the RSI reach extreme values (above 70 or below 30) more often. By the same token, longer timeframe settings will see the RSI indicator reach above 70 or below 30 less frequently. Still awake?

What Is The Best RSI Setting For Day Trading?

The developer of the RSI, J. Welles Wilder Jr. recommends using the 14-period RSI. But other RSI settings can also be good to trade depending on whether you are trading forex, cryptocurrencies or other financial markets and the timeframe you are trading off.

Looking at the chart below, you can compare a 14-day RSI vs. 5 day RSI vs. 50 day RSI setting.

Alert triggers more often at lower RSI period

From the chart above, the 14-period RSI gives several signals, the 5-period RSI is very frequently giving trading signals and the 50-period RSI gives just one very good trading signal throughout the time period selected.

In his book “New concepts in technical trading systems,” Wells Wilder only uses trading strategy examples with the 14-period RSI. Although other RSI settings are certainly possible and potentially profitable, since Wilder created the indicator, we should take time to note why he think his indicator is best setup with 14-periods.

The 14-periods is like a fortnight or half a month. Although markets are not normally open 7 days per week so 14 periods does not equal two weeks, this timeframe has a certain basis in nature relating to the time it takes the moon to travel around planet earth. These natural phenomenon like the Fibonacci sequence have a way of working in trading markets.

In fact, Wilder says in his book that he tested multiple time periods and found 14 to be the most effective for his swing trading style using daily timeframe charts. So his choice of technical indicator settings was based on real evidence from his day trading.

Difference between 70/30 and 80/20 settings

What Is A Good RSI To Buy?

The way Wilder recommends using the RSI is by using the 30 and 70 levels in the oscillator as oversold and overbought levels respectively. This means that when RSI falls below 30, you aim to buy the financial security that has been sold too much and when the RSI reaches over 70, you aim to sell the financial asset that has been bought too much. However these are not the only options.

Is a high RSI good or bad? Some trend following trading strategies use a high RSI level as a sign to keep buying. However, in this instance the RSI is not being used as a trigger to enter a trade but as a guide on the direction of the trend.

A way some successful day traders have found to increase the accuracy or buy and sell triggers from RSI is by changing the definition of oversold and overbought to the 20 and 80 levels , or indeed other levels. Of course, the price will get to these extremes less frequently than 30 and 70, thus in theory offering the most reliable trading signals. The main disadvantage to using 20 and 80 for RSI is that it means missing some potentially good trading opportunities.

The first RSI in yellow uses the (70/30) setting with a 14-day period while the second chart uses the (80/20) setting for overbought and oversold on the same 14-day period timeframe setting.

Both RSI configurations capture the initial buying opportunity. The (80/20) misses the first weak sell signal within the uptrend then both trigger the next poor sell signal. Then both capture the third sell signal which proceeds a nice downtrend. However the (80/20) misses two more buying opportunities and one good opportunity to go short.

How To Trade With RSI?

The use of a divergence trading strategy is possible with multiple technical indicators, including MACD and Stochastic. Which is better: MACD or RSI? Will try to answer that in future.

Divergence happens when the direction of a technical indicator, usually an oscillator ‘diverges’ from the direction of the price action. In essence, the indicator starts moving in the opposite direction to the price.

The change in direction of the indicator is taken by traders to mean that price movements might be about to change direction. The oscillator in this scenario is a leading indicator for the price action.

In the chart below, the price continues to rise but the RSI indicator starts to fall from an overbought position. This is known as bearish divergence. After the price falls following the indicator's signal, the indicator starts to point higher in what is called bullish divergence.

Bearish divergences should normally happen at the end of an uptrend, while bullish divergences happen at the end of an downtrend. The divergence should ideally take place from an overbought or oversold level on the relative strength index.

Is RSI A Good Indicator?

The RSI is one of the most popular indicators for forex traders, cryptocurrency traders, stock traders and futures traders. But it is not the indicator itself that makes users of the RSI successful in trading.

Traders must spend the time to back test an RSI trading strategy to make sure it has worked in the past and then test that strategy in a live trading environment with good trading discipline to have the best chance for a profitable trading strategy that works in the future.

RSI at 70/30 settings to trigger buy/sell signals

Congrats! You survived the RSI trading strategy breakdown. Start setting it up under your chart to back test for yourself. Use it with the other indicatorsto see if it works for you. You may like to refer to the post on 3/25: How to trade S&P 500 index - Tips & Tricks to find out the often used indicators toimprove your trading journey. Have fun! 🤩 

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