Tag: indicator

The RSI Creator’s Dilemma.

Did you ever wonder why the creator of RSI needed to come up with something like the RSI indicator in the first place? What problems were they facing when they were trading?

Actually, there was not just one, but three main problems.

Problem Number 1.

The RSI indicator is famous because it tells us when a price is too high or too low. But did you know that people could still tell if a price was overbought or oversold even before the RSI indicator was created?

In the old days, traders would look at their charts and calculate the average price over a certain number of past candles. For instance, if we calculate the average price over the last 50 candles on this chart, we would get a certain value. If we keep doing this for each new candle, we get an average that keeps changing. You know this as a moving average.

But if the price was a lot higher than this average, traders said it was overbought. If it was a lot lower, they said it was oversold. But the creator of the RSI didn’t like this method. Here’s why:

If there is an uptrend going on, the price can stay above the moving average for a long time. And the difference between the price and the moving average can get even bigger and stay that way for a while. In this case, the moving average saying over-bought is simply not true.

The same thing can happen when the price is in a downtrend. The price can stay below the moving average, and the difference can stay big for a long time. In this case, the moving average gives a false oversold signal.

But there’s another problem. Let’s say the moving average goes up, making the price overbought. Then the moving average comes down and goes back up again, making the price overbought a second time. On the chart, the first overbought pattern is lower than the second one. But even if the second pattern was less over-bought than the first one, it would still appear higher than the first one. This makes overbought analysis very confusing.

If both patterns were on an oscillator like this, you could see that the second overbought pattern was lower than the first one, indicating the second pattern is weaker than the first one. So moving average was a no-go.

Problem Number 2.

But then RSI’s creator didn’t like the oscillator method either. To show you what the problem was, I made my own simple oscillator.

What I did was, I took the closing price of the current candle and then went back 10 candles and took that closing price too. I subtracted the current candle’s closing price from the previous 10th candle’s closing price, and then I drew a dot on the graph. After connecting all the dots, I had a simple oscillator.

Now, this might seem good. But it has a big problem. It’s not clear here since all the candles on the graph are of very different sizes. But if the daily price moves were similar, like if we had around 20 points size candles for multiple days in a row, this oscillator would give us wrong signals.

Actually, the Renko chart shows the same-size candles. So let’s open that.

Now, if you look at this chart, you’ll see the price goes up, then it goes down. The simple oscillator does the same thing – it moves up and then moves down. But, if the candles stay the same size for a while and the price keeps dropping, the oscillator stops dropping. It becomes flat. This means, according to the oscillator, the price isn’t dropping anymore or becoming more over-sold, which is not true.

You can see this pattern better in the next chart. Here, the price begins to move up a lot. At the same time, the oscillator also starts moving up. But, after a few candles that are the same size, the oscillator becomes flat again.

The creator of the RSI didn’t like this second method of analysing overbought and oversold prices. He believed that it gave false signals.

Problem Number 3.

In the old days, they didn’t have the fancy charts we have now, so people had to do a lot of math by themselves to figure out things like indicators. But if the indicator had to use data from a lot of previous candles, it was really hard to calculate all that by hand.

So, RSI’s creator wanted to make something that was easier to calculate. He wanted an indicator that didn’t need lots of data from a lot of past candles to work out its value.

To fix all these problems, he came up with a new indicator called the RSI, or Relative Strength Index. Furthermore, he also suggested 5 RSI trading strategies. This indicator was so useful that many people started adapting it to their trading strategies, and modern charting platforms made RSI an inbuilt indicator. So let’s understand the 5 trading strategies of RSI’s creator with the analogy of tug of war.

Number 1: Tug of war analogy.

Let’s imagine there’s a playground where two groups are ready to play a game of tug of war. There is a straight line drawn in the middle. Now, in our exciting game of tug of war, there’s this long rope that both teams hold onto. The aim of the game is for one team to pull so hard on the rope that the other team crosses that middle line. The stronger team wins the game.

The team on the left side of the line is called Team A, and the team on the right side of the line is called Team B.

Imagine that there’s also a person watching the game, who we’ll call the Spectator. The Spectator loves to draw, so they’ve brought along their drawing pad. The Spectator will draw lines to track the movements of the rope during the game.

When the game begins, Team A uses all their strength to pull on the rope. Team B ends up really close to the middle line. But then, Team A gets tired and can’t pull anymore. Seizing this opportunity, Team B gathers all their strength and pulls back, moving Team A towards them.

Imagine there’s a knot or a marker on the rope that shows which team is pulling the rope towards them. The Spectator, with their drawing pad, traces this marker. If the marker moves towards Team A, the Spectator draws a line on the left side of their paper. If the marker moves towards Team B, the Spectator draws a line towards the right side of their paper.

As the game continues, this back-and-forth tug of war creates this snake-like pattern on the Spectator’s drawing pad.

At this point, another person, who we’ll call Bob, comes along and sees the interesting pattern on the Spectator’s drawing pad. They’re confused and ask, “What’s this weird snake drawing about?” The Spectator explains, “It helps me see which team is stronger and might win the game.”

Confused, Bob asks, “How can a drawing predict who’s going to win?” Just then, Team A pulls again, bringing Team B closer to the middle line. Bob gets excited and says, “See! Team A will win!” But the Spectator, with their drawing pad, disagrees and predicts that Team B will now pull Team A towards the line.

And soon, Team A ends up very close to the line, making the drawing spectator right.

If we turn the spectator’s drawing sideways and add a few horizontal lines, it begins to look more like the “RSI indicator.”

In the trading world, Team A represents buyers, and Team B represents sellers. These buyers and sellers are always competing, just like in our game of tug of war.

In our game, the drawing spectator was able to predict when the A team would lose its strength because he noticed that Team A was consistently losing its strength at around a certain point.

Similarly, the creator of the RSI explained that we could use this tool to identify support and resistance levels that might not be obvious just by looking at the price. For example, if the RSI line is frequently reversing from around the same level, such as the 60 RSI level, and is struggling to cross it, then we can consider this as a resistance level.

On the other hand, if the RSI reverses direction around 40 or 30 frequently and has difficulty moving beyond it, we could see this level as support.

But the creator of the RSI didn’t stop there. He also recommended drawing trend line support and resistance directly on the RSI. For example, if we see that the RSI line is moving downwards and each swing high is lower than the previous swing high, we can connect these swing highs with a line. If the price reverses each time it reaches this line, we can say that the trend line is acting as resistance.

Similarly, if we see that the RSI line is moving upwards and each swing low is higher than the previous swing low, we can connect these swing lows with a line. If the price seems to reverse each time it reaches this line, it suggests that the trend line is acting as support.

Strategy Number 2.

Let’s say our two teams, team A and Team B, are in a tug-of-war game again. Team B manages to pull Team A towards them. But then team A fights back and pulls team B towards them. However, team B isn’t done yet. They pull on the rope again, but this time they can’t pull Team A as far as before. Team A seizes this chance and pulls Team B towards them.

Now, the RSI creator said that this is a really important pattern on the RSI. When the RSI goes all the way to one side into the oversold zone, and then swings back in the opposite direction, then tries to go back into the oversold zone but can’t go as far this time, just like team B couldn’t pull team A as far. When it swings back up again, this is a strong signal that the price could go up.

The same thing happens if it’s the other way around. If the price goes into the overbought zone and comes down, then tries to go back into the overbought zone but doesn’t reach as high as before, and then swings in the opposite direction, this is a strong signal that the price might go down.

The RSI creator gave some names to these moves. When the price goes out of the oversold zone, the highest point it reaches is called the ‘fail point’. When the price goes up again and crosses the ‘fail point’, this is called a ‘failure swing point’. At this ‘failure swing point’, the RSI creator suggests buying.

Similarly, When the RSI comes down from the overbought zone and reverses up, this is another ‘fail point’. Then, when the price goes down again and crosses the ‘fail point’, this is a ‘failure swing point’. At this point, the RSI creator suggests selling.

Strategy Number 3.

RSI’s creator didn’t just talk about trend lines. He also said that you could draw other shapes on the RSI chart that you might not be able to see just by looking at the price. For instance, if you connect a few swing highs and swing lows at the same time on the RSI with trend lines, you could end up drawing a shape like a flag or a triangle.

In trading, when the price starts trading in the middle of a triangle, it’s often viewed as an important sign. The upper side of the triangle acts like a resistance line that the price struggles to cross, while the lower side of the triangle works like a support line that catches the price when it falls.

The RSI creator suggested that if the RSI line breaks through the triangle’s support or resistance, we could potentially see a significant price movement in that direction. He recommended placing trades in the direction of that breakout. While it’s not a guarantee that there will always be a substantial move after a triangle pattern and breakout, he believed that the odds are higher for a move in that direction.

Strategy Number 4.

Now, to understand the 4th strategy from the RSI creator, let’s go back to our game example. Suppose a strong player has joined Team A, and there’s no line in the middle to limit how far each team can pull. When the round starts, Team A, powered by the strong player, pulls Team B with all its might. They pull so much that Team B can only pull Team A a little bit when Team A gets tired. This pattern continues for a while, with Team A pulling towards itself, but with each pull, the strength of Team A decreases. They’re getting tired slowly, and each time they pull Team B towards themselves, the distance they pull decreases.

Now, if we imagine this pull and tug momentum on a graph, it will look like this. Initially, Team A’s pull strength is strong, but as they get tired, their momentum is also decreasing. This creates a line that gradually slopes downwards.

The RSI creator uses this same logic for his fourth strategy. If the price of a stock is moving in one direction, but the RSI line is decreasing, creating a downward line, this is called divergence in trading. The creator suggests that when you see divergence, the probability of the price changing direction increases. If the price is rising and the RSI starts to fall, there’s a higher chance the price will start to drop. Similarly, if the price was falling and the RSI was falling too, but then the RSI starts rising while the price keeps dropping, the likelihood of the price starting to rise increases.

It’s important to note that the RSI creator did not say this is an immediate sign to buy or sell. He simply mentioned that divergence often appears before many price reversals. In my many years of trading experience, I have never found divergence to be a reliable entry tool. In my experience, it’s better to use divergence as an indicator of when to exit a trade rather than enter. For instance, if you’ve bought a stock and you spot RSI divergence, it might be a good time to sell your stock for a profit or move your stop loss to a breakeven point to avoid losses. Similarly, if you’ve taken a short entry and you see an RSI divergence, you might want to close your trade or move your stop loss below the breakeven point to prevent losses.

Strategy Number 5.

The 5th strategy of the RSI creator says that when the RSI goes above 70 or enters the overbought zone, there’s a high chance the market will reach its peak or “top” soon. Similarly, if the RSI drops below 30 or goes into the oversold zone, there’s a good chance the market will reach its lowest point or “bottom” soon. So, if you’ve bought a stock, it might be a good idea to consider selling it when the RSI goes into the overbought zone. On the other hand, if you’ve sold a stock, you might want to close your trade when the RSI goes into the oversold zone to book your profits.

Now the thing is, the creator of the RSI indicator mainly created RSI for higher timeframes such as 1-day and for things that can actually get over-bought and over-sold.
But nowadays, people have adapted this top-and-bottom strategy to modern trading. RSI traders use RSI on pretty much any timeframe and even on things that are not really over-bought and over-sold. But do these new RSI strategies even work? To figure this out, I’m going to test two of these modern RSI trading strategies 100 times each to find their win rates. The first one I’ll test is the Middle Line Entry Strategy, and then I’ll test the Highs and Lows RSI strategy.

Number 1.

Here’s the logic behind the Middle Line Entry strategy:

In the Tug of War game, we saw earlier, there was a line in the middle. Let’s say when the next round starts, Team A pulls Team B towards them and does not let go back that much. The red dot the rope had in the middle stays on Team A’s side for a long time.
The spectator that was drawing draws a snake pattern like this. If you were watching this, you’d probably think Team A has a better chance of winning, right?

RSI traders use this same logic. RSI values range from 0 to 100. But if the buyers are very strong and the RSI value moves above the centre 50 line, and stays above that for a while, RSI traders see this as a strong buying pressure.

Similarly, if the sellers are strong, the RSI value will move below the centre 50 line. If RSI stays below 50 for a while, it’s like there’s more strength in the downward direction.

Using this logic, RSI traders have come up with the following strategy. These are also the same entry rules I used while taking 100 trades with it.

Step 1. Set up the RSI indicator and adjust its settings from the default 14 to 50. This makes the RSI use more data from more candles. This reduces the noise, like short-term changes and helps to identify larger trends.

Step 2. Use a 200-period moving average with the RSI. If the price is above the 200-period moving average and the RSI is also high (but not necessarily overbought), that’s a good sign. Once this happens and the RSI drops down to 50 and then crosses above the 50 line like this, RSI traders take a long entry. Similarly, if the price is below the 200-period moving average and the RSI is also staying low, that’s a good sign to prepare for a short entry. The entry point is when the RSI moves up just above the 50 horizontal line and then moves back down, giving a crossover like this.

Step 3. You should avoid entering a trade while the entry candle crosses the moving average. When I tested this 100 times, I put my stop loss under the swing low in a long setup and above the swing high in a short setup.

Step 4. I set my profit target based on a 1.5 to 1 reward-to-risk ratio. I chose this ratio because we know from past data that it works well for trends. And also so that we can compare this RSI strategy with other strategies we’ve tested so far on the Trading Rush Channel.

After taking trades with this RSI strategy 100 Times, it got a win rate of approximately 45%. Since the breakeven win rate with a 1.5 to 1 reward risk ratio is 40%, this 45% win rate is profitable. However, when comparing it to other strategies we have tested, the win rate is pretty average. But what about the second strategy?

Strategy number 2.

In this strategy, RSI traders use a default RSI of 14 length. We will not use a 200-period moving average because that combination pretty much never gives an entry. You see, many RSI traders in this strategy use 80 and 20 as the overbought and oversold zones instead of the default 70 and 30 zones. They do this so that they can find extreme price moves in one direction, which can increase the probability of the price moving back to its average.

If the RSI goes above the 80 overbought line, RSI traders take a short entry when the price moves below the 80 line. They see this as a sign that the price is losing its upward strength and the top is near.

Similarly, if the RSI goes below the 20 level and then crosses above the 20 line, a long entry is taken. When I tested this strategy 100 times, I set the stop-loss after the swing just like before.
The reward-risk ratio was also 1.5 to 1. However, this RSI strategy also got a win rate of around 45%.

So basically, both RSI strategies many modern traders use are profitable, but the win rate is average to good at best.

However, when we consider the quality of the trades, reliability, consistency in profits, ease to use, and win rate all together to calculate the TR Score, the second RSI strategy we tested actually ranks better. It ranks 9th from the top, below the Weighted Golden Cross Strategy, and above the Alligator Trading Strategy.

As for the first RSI strategy we tested 100 times, it ranks 27th from the top, below the RVI indicator, and above the CMO indicator.

So overall, RSI used to identify extreme overbought and oversold prices, similar to how its creator recommended, is the better RSI strategy.

You can see more comparisons on the Official Trading Rush Website.

So there you have it! RSI creator’s 5 strategies and other modern strategies. That’s all!