The Relative Strength Index, or RSI, is one of the most popular trading indicators out there. If you’ve even dabbled in trading, you’ve likely encountered this powerful tool. Books, websites, videos, and countless tutorials have been dedicated to explaining its intricacies. It’s even likely that your uncle Rob knows about it! However, despite its widespread popularity, an overwhelming 99% of traders use the RSI incorrectly.
For instance, many traders use the RSI to identify overbought and oversold areas. You might be familiar with the concept—the lower line is considered oversold, and the upper line is deemed overbought. If you’ve traded using this approach, you’ve probably realized it works sometimes, but not consistently. This inconsistency might have left you frustrated or doubting the indicator’s value. The truth is, using the RSI this way is fundamentally flawed. Worse yet, the default settings that most traders use are not optimal.
So, what’s the solution? In this guide, we’ll cover how to use the RSI effectively and adjust its settings for better results. Let’s dive in and uncover the real potential of the RSI.
What Is the RSI, and How Does It Work?
The RSI is a momentum oscillator that measures the speed and change of price movements over a specified number of bars. It oscillates between 0 and 100, providing insights into market strength. Its very name—Relative Strength Index—reflects its purpose: to gauge the strength of a trend.
The problem arises when traders plop the RSI onto their charts and rely on it for mean reversion strategies. For example, they interpret oversold readings as signals to go long and overbought readings as signals to short. While this approach might seem logical, it’s flawed. Just because something is “oversold” doesn’t mean it can’t become more oversold, and vice versa for overbought conditions. This misunderstanding often results in poor trading outcomes.
To make matters worse, the default RSI settings of 70 for overbought and 30 for oversold provide a lot of signals—many of which are false. But don’t worry, this doesn’t mean the RSI is useless. It just needs some fine-tuning.
Tweaking the RSI for Better Results
The first step to improving your RSI strategy is adjusting the overbought and oversold levels. Instead of the default 70/30 settings, try changing them to 80/20. This adjustment reduces the number of signals but increases their quality, making them more reliable.
Next, consider adding a layer of confirmation by using multiple timeframes. For instance, if the RSI on the hourly chart gives you a signal, check the daily chart to see if it aligns. If the higher timeframe doesn’t confirm the signal, it’s better to stay out of the trade. This simple tweak significantly improves the reliability of your RSI signals.
Here’s an example: suppose you’re trading on the 1-minute chart, and the RSI enters the oversold zone. Before taking action, check the RSI on the 5-minute chart. If the 5-minute RSI isn’t in the oversold zone yet, wait. Once both the 1-minute and 5-minute RSIs confirm the signal, you’ll have a stronger case for entering the trade. For even more assurance, you can check the 15-minute chart as well.
Using Price Action to Validate RSI Signals
Even with refined RSI settings and confirmation from multiple timeframes, relying solely on the RSI isn’t enough. Incorporating price action into your strategy can further improve your odds.
Let’s say the RSI on multiple timeframes signals a potential short trade. To add another layer of confirmation, look for price action patterns such as double-bar breaks. For example, if two candles show hesitation and the price breaks below their low, it’s a strong bearish signal. At this point, you can confidently enter the trade.
To manage your risk, place your stop loss just above the recent high. As for taking profits, one approach is to take partial profits when the RSI returns to its midline (around 50). For the rest of the position, you can aim for a price level like the Volume Weighted Average Price (VWAP). This method allows you to lock in profits while letting the rest of your trade run.
A Better Way to Use the RSI: Trend Confirmation
While many traders use the RSI to find overbought and oversold areas, this wasn’t its original purpose. The RSI was designed to measure strength, as its name suggests. A more effective way to use it is by focusing on trends and pullbacks.
In strong uptrends, the RSI tends to stay between 50 and 80, oscillating within this upper range. Similarly, in strong downtrends, it tends to remain between 20 and 50, staying within the lower range. This behavior can be used to identify pullbacks and trend continuation opportunities.
Here’s how it works:
- Identify a trending market. If the market is moving sideways, this strategy won’t be effective.
- In an uptrend, wait for the RSI to pull back to the midline (around 50).
- Enter the trade, expecting the price to bounce off the midline and continue upward.
For short trades, look for a strong downtrend and wait for the RSI to rise to the midline. Once it does, enter the trade, anticipating a continuation of the downtrend.
This approach works beautifully, especially when combined with price action signals. For example, if the RSI reaches the midline in a downtrend and you see a bearish candlestick pattern, it’s a strong indication to short the market.
Combining RSI Strategies for Maximum Impact
Both strategies—overbought/oversold signals and trend confirmation—can be highly effective when used correctly. To maximize their potential, combine them with price action techniques and multiple timeframes.
For instance, in a trending market, use the RSI to identify pullbacks and confirm the strength of the trend. At the same time, keep an eye on overbought and oversold signals across multiple timeframes to spot potential reversals. By layering these strategies, you’ll significantly improve your trading accuracy.
Conclusion
The RSI is a versatile and powerful indicator, but it’s often misunderstood and misused. By tweaking its settings, incorporating multiple timeframes, and validating signals with price action, you can transform it into a reliable tool for your trading arsenal.
Remember, no indicator is foolproof, and false signals are inevitable. However, by following the techniques outlined here, you can limit false signals and increase the quality of your trades.
In the next part, we’ll dive into advanced price action strategies that pair perfectly with the RSI. Stay tuned, and watch your trading profits soar!
