A trading strategy using RSI (Relative Strength indicator) has default settings of 14 periods and 70/30 levels. But does this provide a good price to buy?
- How will the RSI setting change the indicator trading signals?
- What is the best RSI setting for day trading?
- What is a good RSI to buy?
- How do you trade with RSI?
- How do you use RSI strategy?
- Conclusion: Is RSI a good indicator?
How will the RSI setting change the indicator trading signals?
The RSI setting will affect how frequently the RSI gives overbought and oversold signals as well as divergence signals to buy and sell.
What does RSI 14 mean? 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.
The below shows how to change the various settings in the FlowBank trading platform.
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.
It can be observed that 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.
Firstly, 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.
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 FlowBank trading platform conveniently allows you to set the overbought and oversold levels. The below chart shows the way the settings affect the trading signals that would have been taken from the RSI indicator.
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 do you trade with RSI?
The use of a divergence trading strategy is possible with multiple technical indicators, including MACD and Stochastic. What is better MACD or RSI? Really neither one is better but divergence only works on an underlying price chart.
Divergence is when the direction of a technical indicator, usually an oscillator ‘diverges’ from the direction of the price. In essence, the indicator starts moving in the opposite direction to the price.
The change in direction of the indicator is taken by forex traders or other traders to mean that price movements might be about to follow in the same direction. The oscillator in this scenario is a leading indicator for the price.
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 signal the indicator starts to point higher in what is called bullish divergence.
NOTE: Bearish divergences should normally happen at the end of an uptrend, while bullish divergences happen at the end of an uptrend. The divergence should ideally take place from an overbought or oversold level on the relative strength index.
How do you use RSI strategy?
Wilder advocated RSI indicator trading strategies complementing the use of oversold and overbought levels with the concept of divergence. The choice of indicator settings is best found through experience by each individual trader. Try different settings to see which work for your trading strategy or trading system.
Here is one example of an RSI trading strategy to consider as a guideline for how to go about developing your own trading system.
RSI (2-period) (90/1)
This RSI trading strategy was developed by Larry Connors and the idea is to find periods when the short term trend is deeply oversold within an overall price uptrend or when the short term trend is hugely overbought in an overall downtrend.
Because it is intended for entry point within a trend, Connors uses a much more sensitive lower timeframe - 2 periods on the RSI. Because 2 is such a short timeframe, Connors attempts to filter out the false signals by using the 90 and 10 levels instead of the 70 and 30 levels for overbought and oversold. In essence this a trading method to buy the dip and sell the rip.
Here are the steps to using this RSI strategy:
- Plot a 200-period simple moving average (SMA) to determine the overall price trend.
- Add the RSI indicator and change the settings to 2 periods.
- Adjust the levels for overbought and oversold to 90 and 10.
RSI Buy signal = When price > 200 SMA & RSI(2) < 10
RSI Sell signal = When price < 200 SMA & RSI(2) > 90
The below chart shows a picturesque bull market in the Nasdaq index, Connors’ RSI trading strategy only has one false signal and six strong signals.
Of course, in different trading environments the trading system will perform differently. For example, in a choppier trend or sideways price range, the 200 SMA will be less reliable as a trend indicator.
Conclusion: 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.