Trading With The RSI

Our first trading strategy to be presented on is called Trading with the RSI and it implies looking at the RSI (Relative Strength Index) and how to trade binary options based on it.

The whole interpretation of the strategy is divided into four different recordings (four different parts) and this text has the purpose of guiding you through the setups for this strategy.

The first recording deals with how to actually apply the RSI indicator to a chart and it should be noted that we are showing both the JForex and the Metatrader here. These are one of the most popular trading platforms available for the general public and the RSI is to be found under the momentum indicators on the JForex platform and under the oscillators tab on the Metatrader.

After installing the indicator on a chart it should be noted that the period to be used should be the default one, the 14 period as any broker in this world would have the 14 period as the default setting for it. And the RSI interpretation is the right one using the default setting.

Trading with the RSI is a straight forward thing in the sense that there is no trader in this world that didn’t hear about this indicator but just the fact that is so popular it doesn’t make it easier to understand it. Also, one should consider the type of trading or the markets to be traded with the RSI as it is one thing to trade the spot markets on the foreign exchange for example or to trade binary options.

The second recording there has the purpose of showing one of the two ways the RSI is used in trading.

Any broker will offer the RSI with the 70 and 30 levels and the standard interpretation is that anything that goes above the 70 area in the RSI is considered to be overbought and anything that goes below the 30 level in the RSI is considered to be oversold. When trading binary options this is actually translating into buying call options when RSI is coming in the 30 area and put options when RSI is coming in the 70 area.

However, is this working all the time? Definitely not. This is working always, whenever a range is identified. In other words, if a consolidation pattern, like a contracting triangle or a flag for example is identified on the bigger time frame, then the logical thing to do is to go on the lower time frames and trade the overbought and oversold levels on the RSI. The recording that comes with this chapter shows you exactly how to treat a contracting triangle identified on the hourly chart and how to trade it on the five minutes chart based on the overbought/oversold levels, and, more importantly, what expiration dates to be used.

Taking into account the fact that markets are spending most of the time in consolidation areas, making lots of consolidation patterns, this approach to use on the RSI seems to work best.
But what to do when markets are ending the consolidation areas and price is trending? Is it possible to use the RSI for finding the beginning or the end of a trend? The answer is yes, and the way to do it is to look for divergences.

The third part of this small project shows you the current usdjpy hourly chart and explains clearly what a divergence is.

Because of the fact that the RSI is an oscillator, its moves need to be in line with the moves price is making. However, from time to time, there are situations in which price is diverging from the oscillator, meaning one goes into one direction while the other one goes into a totally different direction. This is being called a divergence and it means that one of the two (price or oscillator) is lying. And the convention is that the price is the one that makes a fake move on such a situation so we should always stick with what the oscillator is showing us.

In the recording that comes with this part there are a couple of examples on how to identify a divergence and both examples there are referring to bearish divergences. A bearish divergence is forming when price is making two consecutive highs but the oscillator (RSI) is failing to make the second highs, basically not confirming the second high. If you take a trend line and connect the two points on price and the two points on the RSI you can see the line on the price is rising while the one on the RSI is falling. But we should always stick with the RSI and because the second high price made is not confirmed by the oscillator we are saying that this is a bearish divergence.

As a consequence, the normal thing is to buy put options and the expiration date depends very much on the time frame the divergence is identified on. In our example here we are having a bearish divergence on the hourly usdjpy chart and the expiration date to be used depends on the moment of time during the trading day the signal is identified.

If, for example, the divergence appears in the second half of the trading day, even end of day expiration dates can be used as such expiration dates are offered by the majority of brokers and for a lot of currency pairs. Otherwise, hourly or couple of hours should work as well for this time frame.

The last part of this project deals of course with the bullish divergence and the examples used are on the five minutes chart. The reason for that is the fact that I wanted to prove that it works on any time frame and of course that the expiration dates to be used now are different.

Short term expiration dates can be used (sixty seconds, two minutes, five minutes), but also medium ones (30 minutes, one hour, etc.).

A bullish divergence appears when price is making two consecutive lows, but the RSI fails to confirm the second low. In other words, price is falling, while RSI is rising, and the thing to do in such a situation is to look for price to move to the upside.

When trading binary options, a move to the upside should be traded by buying calls, as this means that at the expiration date price should be bigger than the striking price (the price you bought the option for). This is what the last recording of this small project shows and it is offering a clear understanding of what a bullish divergence is and how to trade it on the small time frames with the appropriate expiration dates.

In conclusion, trading with the RSI can be made in two different ways:

  • trading the overbought/oversold levels (the 70 and 30) levels when a consolidation pattern like a contracting triangle of a flag is identified;
  • looking for divergences between price and RSI and buying call options on a bullish divergence and put options when a bearish divergence is identified.

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