Month: May 2024

Introduction

In our past article “Which is better for stock trading, THE RSI or THE MACD?”, we learned that the RSI indicator is a momentum oscillator used by traders to assess and predict price movements. We also learned that it measures recent price fluctuations to determine whether a stock is overbought (RSI > 70) or oversold (RSI < 30).

What we haven’t talked about, however,  is how traders use the RSI indicator in the stock market as part of their strategy… but that’s only because RSI trading strategies are the topic of today’s article.

Ready?
Let’s dive in!

The 6 most popular RSI-based Trading Strategies

As for all technical indicators, the RSI can be used in many different ways and each trader has his favorite. Traditionally, the RSI is used as an entry indicator or a confirmation indicator but often traders use it as an exit indicator too. By getting familiar with it and practicing, you’ll be able to decide if and how it best fits your trading strategy and style.

To help get you started, we collected the 6 most popular and effective stock trading strategies based on the RSI indicator.

Here they are:

1. Basic RSI Buy/Sell Trading Strategy

   This simple strategy involves purchasing stocks when the RSI falls below a specific threshold, typically 30, indicating an oversold condition. Conversely, it suggests selling stocks when the RSI surpasses a certain threshold, commonly 70, indicating an overbought condition.

   Execution:

   Buy Signal: Buy when the RSI drops below 30. (It signifies that the stock is potentially oversold, and there may be an upcoming price increase).

   Sell Signal: Sell when the RSI exceeds 70. (It indicates that the stock is potentially overbought, and price might start decreasing soon).

   Example: Suppose stock XY’s RSI declines to 28; this could be an opportune time to buy if confirmed by other indicators. Conversely, if Stock AMZN’s RSI rises to 72, it may be a good time to consider selling.

2. RSI Divergence Trading Strategy

   RSI divergence occurs when there is a contrasting movement between the RSI and the stock price. This can potentially signify a reversal in the trend.

   Execution:

   Bullish Divergence: This happens when the stock price reaches a new low while the RSI forms a higher low. This suggests that the selling pressure is diminishing, and there may be a forthcoming bullish reversal.
   

   Bearish Divergence: This occurs when the stock price reaches a new high, but the RSI forms a lower high. This indicates that the buying momentum is weakening, and there might be a bearish reversal approaching.

   Example: For instance, stock XY’s price hits a new low, but the RSI does not follow suit and instead forms a higher low, this could indicate that the stock is likely to undergo a bullish reversal.

3. Swing Rejection Trading Strategy.

   The RSI Swing Rejection Strategy is a method that combines RSI levels with specific rejection patterns to identify possible price reversals. It relies on the concept of “failure swings” to validate the signals of a reversal.

   Execution:

   There are two types of swing rejections: bullish and bearish.

   Bullish Swing Rejection Pattern: this pattern occurs when:

   1. the RSI goes into oversold territory (below 30)
   2. the RSI crosses back above 30
   3. the RSI forms another lower low without crossing back into the oversold territory, and, finally
   4. the RSI rises and breaks its recent high

   This bullish swing rejection pattern is seen by traders as strong signal of a potentially imminent bullish price move.

   Bearish Swing Rejection Pattern: contrary to its bullish counterpart, a bearish swing rejection occurs when:

   1. the RSI goes into overbought territory (above 70)
   2. The RSI crosses back below 70
   3. the RSI forms another higher high without crossing back into the overbought territory and, lastly
   4. the RSI breaks its recent low

   Where a bullish swing rejection pattern is seen as a sign of possible bullish move in price, it’s only natural that a bearish swing rejection pattern would signal traders to prepare for a potential downtrend instead.

   Example: let’s consider any stock XY If its RSI drops below 30 and then rises above 30, followed by forming a higher low while the RSI remains above 30, and finally breaks its recent high, it indicates a potential bullish swing rejection.

4. RSI with Moving Average Crossover Trading Strategy

   This technique integrates the Relative Strength Index (RSI) with moving average (MA) crossovers to generate more reliable trading signals.

   Execution:

   Apply a short-term moving average (e.g., 10-day) alongside a longer-term moving average (e.g., 50-day).

   Buy Signal: When the RSI surpasses 30 and the short-term MA rises above the long-term MA, this indicates a potential upward trend.

   Sell Signal: When the RSI dips below 70 and the short-term MA falls below the long-term MA, this signifies a possible downward trend.

   Example: Consider Stock XY, where the RSI climbs above 30 while the 10-day MA simultaneously moves above the 50-day MA. This could be interpreted as a strong buy signal. On the other hand, if the RSI drops below 70 and the 10-day MA sinks beneath the 50-day MA, it may suggest that it’s time to sell.

5. RSI Trendline Trading Strategy

   This method entails drawing trendlines on the Relative Strength Index (RSI) to detect possible breakouts that correspond with price fluctuations.

   Execution:

   Recognize a trend by sketching a trendline on the RSI, such as linking the peaks or troughs of the RSI.
   A breakout from this RSI trendline may signal a potential shift in the price direction.

   Example: For instance, if Stock XY’s RSI downtrend line is surpassed as the RSI moves upward and crosses above the trendline, this could suggest a bullish breakout.

6. Stochastic RSI Trading Strategy

   
   A stochastic RSI strategy combines The RSI with another popular technical indicator – the Stochastic Oscillator. Both the RSI and the Stochastic are oscillators focused on identifying overbought and oversold conditions in the market and some traders like to use them both simultaneously.

   Execution:

   Look for divergence between the two indicators. For example, if the RSI is showing a strong trend but the Stochastic Oscillator indicates overbought conditions, it might signal a potential reversal. Define entry and exit points based on the signals generated by both indicators. For example, entering a trade when the RSI crosses above a certain level and the Stochastic Oscillator confirms the bullish signal.

Conclusion

The RSI indicator serves as an extremely versatile indicator for traders, helping them pinpoint potential entry and exit levels within the market.

The strategies we spoke about – as well as many others –  offer valuable insight and perspectives that allow traders to analyze the market in all its varying market conditions.
Get some practice trading with the RSI on your chart and see if it helps to trade better and more efficiently. In the meantime,

I hope this helps.

Watch our hosts Scott and Mitch discuss indicators on our live trading room!

Introduction

As anyone who has ever traded knows, technical indicators are tools that assist traders in analyzing and making decisions about market trends and potential price movements. Nowadays, there are literally thousands of different indicators out there. They come in all shapes and forms, analyze different aspects of asset trends and, for the vast majority, are free and easy to obtain. One could say “Traders have never had it easier”. However, despite the huge number of readily available technical indicators, there are a few that seem to be more popular than others and part of most traders’ strategies (at least in some measure). Two such indicators are the RSI (Relative Strength Index) and the MACD (Moving Average Convergence Divergence).

In this three-part article, we’ll start by taking a schematic view of each of the two indicators to better understand their characteristics, their uses, and the differences between them. This will also give everyone the chance to identify the best suited to his or her strategy.

In the second and third articles, we’ll then dive together right into the most popular trading strategies based on both the RSI and those based on the MACD so that once you know which one is your favorite, you’ll also know how to use it in the best way.

Interested?
Thought so.

The RSI and the MACD

The RSI and the MACD are two of the most widely recognized indicators and they are often used in conjunction as each serves a different function and provides its unique insight into market behavior.

Understanding the differences, applications, and advantages of RSI and MACD can further improve your decision-making, your strategy, and your trading, and who wouldn’t want that?

What is the RSI?

The relative strength index (RSI) measures the momentum by assessing the speed and magnitude of price movements, allowing traders to evaluate whether an asset is overvalued or undervalued. The RSI helps identify potential buying or selling opportunities based on the relative strength of the asset’s price movements.

Overbought and Oversold Conditions

The RSI indicator oscillates on a scale between 0 and 100 and, traditionally, any value higher than 70 is interpreted as a signal that the asset is overbought. Conversely, when the RSI value falls below 30, it suggests that the asset may be oversold instead. These specific thresholds are valuable indicators for traders as they can help predict potential reversals or continuations in market trends.

RSI Divergence Indicator

Another way that the RSI can be analysed and used is as a divergence indicator divergence which can also indicate the potential for reversals.
For example, if the price of an asset is reaching new highs, but the RSI fails to surpass its previous high, the bearish RSI Divergence created works as a warning to traders for a potential price reversal. On the other hand, if the price reaches new lows while the RSI remains high, the divergence could signal that price could soon start moving upwards.

(More on “What is the RSI?”, “Overbought/Oversold signals”, and on “The RSI Divergence Indicator” coming up in the next article – 2/3).

What is the MACD

The MACD is an indicator that follows trends and measures the momentum of an asset’s price by comparing two different moving averages. It is calculated by subtracting the 26-period Exponential Moving Average (EMA) from the 12-period EMA, resulting in the MACD line. Additionally, a 9-day EMA of the MACD, known as the signal line, is plotted on top of the MACD line. This signal line can act as a trigger for buying and selling signals.

Histogram

The MACD histogram visually represents the difference between the MACD line and the signal line. It provides a clear depiction of the momentum of price movements.

Crossovers

Crossovers occur when the MACD line intersects with the signal line. When the MACD line crosses above the signal line, it is considered a bullish signal, indicating that it may be a good time to buy. Conversely, when the MACD line crosses below the signal line, it is typically seen as a bearish signal, suggesting that it might be time to sell.

(More on the “MACD Histogram”, “MACD Crossovers”, and MACD signals interpretation in the article 3/3 on RSI and MACD)

RSI Vs MACD

RSI and MACD are both momentum indicators that traders use to assess market conditions. However, they have distinct purposes and provide different information.

RSI Vs MACD – Purpose and Usage

RSI: The primary purpose of RSI is to identify overbought or oversold conditions in the market. It helps traders determine if the current price trend is likely to experience a correction or reversal. RSI is particularly valuable in range-bound markets where prices fluctuate between support and resistance levels.

MACD: On the other hand, the MACD is used to identify changes in the strength, direction, momentum, and duration of a trend. It is especially useful in trending markets where the objective is to ride the trend for its entire duration.

RSI Vs MACD – Components and Calculation

RSI: RSI is calculated by averaging gains and losses over a specified period, typically 14 days. The result is a single value that oscillates between 0 and 100.

MACD: MACD involves the calculation of two exponential moving averages (EMAs) and the difference between them. It provides multiple components for analysis, including the MACD line, signal line, and histogram.

RSI Vs MACD – Type of Markets

RSI: Most suitable for markets that are range-bound. RSI performs well in situations where the price fluctuates within a horizontal trading range, as it assists traders in identifying points of reversal.

MACD: Ideal for markets that are trending. MACD is advantageous in markets where prices are consistently moving in a particular direction, either upward or downward, as it helps traders capture the ongoing momentum.

RSI Vs MACD – Potential Drawbacks

RSI: One of the main disadvantages of RSI is that it can produce false signals during strong trending markets. For instance, in a strong uptrend, RSI may remain in the overbought range for an extended period, causing traders to prematurely anticipate a reversal.

MACD: The MACD can sometimes lag behind real-time price movements because it relies on historical data. This lag can result in delayed signals, potentially causing traders to miss out on optimal entry or exit points.

Combining RSI and MACD

Although RSI and MACD are two separate indicators, their combined use can lead to a more accurate and comprehensive technical analysis. Here’s how it works:

Signal Confirmation: When both RSI and MACD generate the same signal, it provides traders with an increased level of confidence in their decision-making. For example, if RSI indicates that an asset is overbought and MACD triggers a bearish crossover, the combined signal suggests a stronger case for considering a potential sell.

Noise Filtering: The combination of RSI and MACD helps filter out false signals. If RSI indicates an overbought condition but MACD does not show any signs of bearish momentum, traders may choose to exercise caution and refrain from making impulsive decisions.

Identification of Divergences: Both RSI and MACD are effective in identifying divergences. When both indicators show divergence from the price action, it strongly indicates a potential trend reversal.

By utilizing the combined power of RSI and MACD, traders can make more informed and confident trading decisions while minimizing the impact of false signals and identifying potential trend reversals.

Conclusion

RSI and MACD are two valuable instruments for technical traders.

The RSI is particularly effective in identifying instances where the market is either overbought or oversold in range-bound conditions. The MACD, on the opther hand, is most useful in trending markets as it highlights changes in momentum and trends. By comprehending the distinct qualities of these tools and skillfully combining them, traders can gain a more comprehensive understanding of market dynamics and enhance their decision-making process.

Ultimately, successful trading relies on utilizing a diverse range of indicators and continuously refining one’s strategy based on market conditions and performance analysis so don’t stop learning and don’t stop trading!

Hope this helps.