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Don't Use RSI Until You Watch This Video — Transcript

by FXStreet · 1,718 words · 287 segments · language en · Watch on YouTube

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0:00Don't use the RSI until you've watched
0:02this video
0:03because the relative strength index
0:05indicator is one of the most
0:07misunderstood tools in trading. Traders
0:10often see the words overbought or
0:13oversold and they immediately assume
0:15that means to sell or buy. That simple
0:18interpretation can be extremely costly.
0:22I'm going to show you how to use the RSI
0:24correctly and highlight a trade plan
0:27with a high hit ratio.
0:30One of the best known momentum
0:32indicators is the relative strength
0:34index or the RSI. It was developed by J
0:38Welles Wilder. The RSI measures the
0:41magnitude of recent upward and downward
0:44price movements over a specified period,
0:48traditionally 14 periods, and displays
0:51the results on a scale 0 to 100.
0:55The conventional interpretation is
0:57straightforward.
0:59Above 70, overbought. Below 30,
1:03oversold. And around 50, we're neutral.
1:07But this is where many traders go wrong.
1:09Overbought does not mean price is too
1:12high. And oversold, that doesn't mean
1:14that price is too low. The RSI is
1:17measuring momentum and not value. And
1:21once you understand that distinction,
1:23the way you interpret the RSI completely
1:26changes.
1:27Let me explain why. The RSI compares the
1:30magnitude of recent positive price
1:34changes with the magnitude of recent
1:37negative price changes. Wilder's formula
1:40is where RSI equals the average gain
1:45divided by the average loss. If recent
1:48gains are considerably stronger than
1:50recent losses, the RSI rises. If recent
1:54losses dominate, the RSI falls. So, an
1:58RSI reading of 75
2:01isn't telling you this market is too
2:03expensive and must fall. It is telling
2:06you that the upward momentum has been
2:09particularly strong during the
2:11measurement period. That's a completely
2:14different message. This results in one
2:17of the biggest mistakes traders make and
2:19the most important lesson to be learned
2:22with the RSI. They see an extreme
2:26reading and immediately try to trade
2:28against it. Overbought is not a sell
2:32signal. Oversold is not a buy signal.
2:35During strong trends, markets can remain
2:39overbought or oversold for surprisingly
2:43long periods. Suppose the US dollar
2:46against the Canadian dollar enters a
2:48powerful bullish trend.
2:51The RSI reaches 75. The trader sells.
2:55Dollar CAD, it continues higher. RSI
2:58reaches 78. The trader sells again. The
3:02price continues higher. RSI reaches 81.
3:06The trader concludes that the market is
3:08now extremely overbought and adds
3:11another short position. But the trader
3:14is misunderstanding what RSI is saying.
3:17The increasing RSI readings aren't
3:20necessarily warning that the rally is
3:22about to collapse. They are
3:24demonstrating the strength of the buying
3:27pressure. This is why blindly fading
3:30into a position using RSI extremes can
3:33result in traders repeatedly fighting
3:36major trends. So, if overbought doesn't
3:40mean sell and oversold doesn't mean buy,
3:45how can the traditional RSI approach be
3:47useful? The answer starts with
3:50understanding the market you're trading.
3:52In a range bound market, the traditional
3:55approach can work reasonably well.
3:58RSI moves towards 70 as price approaches
4:02resistance and towards 30 as price
4:05approaches support. You might therefore
4:08see resistance plus RSI above 70,
4:13potential short, and support plus RSI
4:17below 30, potential long. But you should
4:20always know in which direction the
4:23consolidating pattern has a bias to
4:25break and only trade on that side.
4:29Consolidating pattern after an initial
4:32rally may have a bias to break to the
4:34upside. Buy trades should be considered.
4:38A consolidating pattern after an initial
4:41sell-off may have a bias to break to the
4:44downside. Sell trades should be
4:46considered. But trending markets behave
4:50differently. During a strong bullish
4:52trend, the RSI may repeatedly move above
4:5670 while corrections struggle to push it
4:59below the 50 to 40 zone. And during a
5:03strong bearish trend, the RSI can
5:05repeatedly fall below 30 while rallies
5:09they struggle to push above the 50 to 60
5:12zone.
5:13And this is where the RSI becomes more
5:15interesting. Instead of asking whether
5:18RSI is above 70 or below 30, we can
5:22start asking what range is the RSI
5:26respecting. This gives us a much more
5:29sophisticated way of using the
5:31indicator. We look at RSI ranges. A
5:35bullish market might broadly operate
5:38within an RSI range of approximately 40
5:41to 80.
5:43While a bearish market might operate
5:45closer to 60 to 20.
5:48These aren't rigid numbers. The
5:50important concept is the shift in the
5:52RSI regime. Instead of asking, "Is the
5:56RSI overbought?" ask, "What is the RSI
6:00behavior telling me about the underlying
6:04trend?"
6:05That's a far more useful question.
6:09That shift in thinking is important
6:10[music]
6:11because now we're using the RSI to
6:13understand market behavior rather than
6:17simply reacting to an indicator's
6:19reading. And the 50 level is also highly
6:23underrated.
6:24Most traders concentrate almost entirely
6:27on 70 and 30. I would argue that 50 can
6:32often be more useful because the RSI
6:35measures the relationship between upward
6:38and downward momentum. The midpoint
6:40provides a simple indication of which
6:44side currently has greater momentum.
6:48Generally, above 50 equals bullish
6:51momentum. Below 50, bearish momentum. So
6:56far, we've looked at RSI extremes,
6:59ranges, and the 50 level. But there's
7:02one RSI technique I find particularly
7:05useful if I'm looking for a potential
7:08change in the trend. My favorite use of
7:11the RSI strength indicator is to
7:14highlight divergence.
7:16>> [music]
7:16>> Bearish divergence occurs when price
7:19makes a higher high, but the RSI makes a
7:23lower high.
7:25Bullish divergence occurs when price
7:27makes a lower low, but the RSI makes a
7:31higher low.
7:32Traders, they frequently interpret
7:35divergence as an immediate reversal
7:37signal. Again, that's a mistake.
7:40Divergence tells you that momentum is
7:43changing relative to price. It doesn't
7:46tell you exactly when the market will
7:48reverse.
7:49A market can produce bearish RSI
7:52divergence and continue rising for
7:54several sessions or even produce
7:57multiple divergencies before eventually
8:01turning lower. Therefore, divergence is
8:04a warning, not a trigger.
8:07And this distinction is critical. A
8:10divergence can tell me that momentum is
8:12no longer confirming price, but it still
8:16doesn't give me an entry.
8:18So, how can we use the RSI divergence to
8:21predict likely market moves and more
8:24importantly produce a solid trade plan?
8:28My favorite chart pattern to use in
8:31conjunction with the RSI divergence is
8:34the ending wedge because [music] it's
8:37easy to identify. It [snorts] has
8:40defined support and resistance barriers.
8:44>> [snorts]
8:44>> It is often seen at the end of a trend,
8:47especially after the completion of an
8:49impulsive Elliott wave count.
8:52And the most important factor, it has a
8:55defined target level called the measured
8:58move. So, the RSI tells us that momentum
9:02may be changing and the ending wedge
9:04formation that gives us a price
9:07structure that we can actually trade.
9:09This is where I bring the two ideas
9:11together.
9:13First, [music] I want to identify the
9:15existing trend.
9:17Second, I want to identify an ending
9:20wedge formation. Third, I want to see
9:23whether the RSI is confirming the price
9:26or producing a divergence.
9:30And fourth, I still need the price to
9:32confirm the trade before I enter. The
9:36divergence gives me the warning. The
9:39chart pattern gives me the structure,
9:42and the price action gives me the entry,
9:44the stop, and the target. Let's look at
9:47some examples. First, I want to identify
9:50the current trend. Here, we can clearly
9:53see higher highs and higher lows,
9:56highlighting a bullish trend.
9:59Second, I want to identify an ending
10:02wedge pattern.
10:04Third, I want to see if the RSI is
10:07confirming the price action or producing
10:10divergence. Here, we can see the chart
10:13making higher highs
10:15>> [music]
10:15>> and the RSI making lower highs,
10:18highlighting divergence.
10:21And fourth, I need the price action
10:24to confirm
10:25the trade before I enter. Here, I can
10:29see a bearish outside candle. From that
10:33point, we can calculate our trade plan,
10:37our entry,
10:39our stop,
10:40and our target.
10:47Next, let's look at DXY. This is the
10:51dollar index. Remember, first we want to
10:53identify the existing trend. Here, we
10:57can see the completion of a bearish
11:00Elliott wave count. Secondly, we want to
11:03identify the ending wedge pattern.
11:07Third, I want to see whether the RSI is
11:09confirming the price action or producing
11:12divergence. Here, we can see the chart
11:15making lower lows while the RSI is
11:19making higher lows, highlighting bullish
11:23divergence. And fourth, I still need the
11:26price to confirm the trade before I
11:29enter. And here, we can clearly see a
11:33morning doji star pattern.
11:43>> [snorts]
11:43>> Lastly, let's look at the US dollar
11:46against the Japanese yen. First, we need
11:48to identify the trend. Here we can see
11:50higher highs and a higher lows. Second,
11:54I want to identify the ending wedge
11:57formation. And third, I want to see
12:00whether the RSI is confirming the price
12:02action or producing divergence. Here we
12:06can see the chart making higher highs
12:08while the RSI is making [music] a lower
12:12high. And fourth, we need the price
12:15action to confirm the trade before we
12:17enter. And here we can see a bearish
12:21outside bar. That candle formation is
12:25often seen at the top of a trend and the
12:27start of a new downward bias.
12:36And notice what has happened here. We
12:39haven't taken a trade simply because the
12:41RSI was overbought or oversold. We've
12:45built a plan. Trend momentum,
12:48divergence, price structure,
12:51confirmation, invalidation, and a
12:54target. There are claims that the ending
12:56wedge and RSI divergence combo has a hit
13:00ratio coming in at around 80%. I think
13:03that statistic might be a little bit
13:05over ambitious, but I do know from
13:07personal experience it produces far more
13:10winners than losers. So let's bring this
13:13all together. The RSI is not simply an
13:17overbought or oversold indicator. It's a
13:21momentum tool. 70 does not automatically
13:25mean sell and 30 does not automatically
13:28mean buy. Use divergences with price and
13:32combine with chart patterns such as the
13:35ending wedge. So, the next time you see
13:37the RSI above 70, don't automatically
13:41think sell. Just plan the trade and
13:44trade the plan.
13:46So, there we have it, a full explanation
13:49of the relative strength index, the most
13:52understood indicator in technical
13:54analysis. If you're looking at trading
13:57the ending wedge and the RSI divergence
13:59combo with the Elliott wave formation, a
14:03full series of the study can be found
14:05here.

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