How To Use RSI

The Relative Strength Index (RSI) is a momentum oscillator that measures the velocity and magnitude of price movements over a specified time frame. It quantifies price fluctuations on a scale from 0 to 100, offering insights into potential overbought or oversold conditions, as well as possible trend reversals.

RSI is applicable across various markets and asset classes, including equities, foreign exchange (forex), and commodities, and can be employed with a multitude of trading strategies.

Like most oscillators, RSI is typically plotted beneath a price chart and can be used on any timeframe.

The RSI indicator has numerous applications and can be interpreted in various ways within trading and technical analysis, including divergence, overbought and oversold conditions, and trend line analysis.

In this article, we will delve into different forms of divergence and provide illustrative examples.

Types of Divergence

There are two primary types of divergence, each interpreted differently:

1. Normal Divergence: Normal divergence is prevalent across forex, equities, cryptocurrencies, commodities, and literally any financial instrument. It frequently occurs and suggests that the current trend or market condition is weakening, potentially signaling a reversal or corrective phase. This makes it valuable for identifying entry points during potential market reversals or for advising caution against continuing with the prevailing trend until a pullback occurs. For instance, during an uptrend where the price consistently achieves higher highs, a corresponding decline in the RSI (for a bullish trend) may be observed, as depicted in Figure 1.1.

Figure 1.1
The confirmation of RSI weakening in an uptrend often precedes a substantial downward correction.
To further illustrate, consider a bearish scenario. If you are looking to purchase a stock and are evaluating numerous support zones for optimal entry, the RSI can be a critical tool.
By analyzing RSI divergence, you can streamline your support zones and wait for a positive RSI divergence, indicating that bearish momentum is diminishing and consolidation is occurring. This provides a strong confirmation for identifying an optimal entry point.
It is crucial to note that the presence of divergence does not guarantee a market reversal. Initially, identify key support or resistance levels. Once the price reaches these zones, examine the RSI for any divergence signals.
As demonstrated in Figure 1.2, while the price is forming lower lows, the RSI is exhibiting higher lows.

Figure 1.2

2. Hidden Divergence: This form of divergence is less common but equally significant, primarily used to identify trend continuation signals. In a bullish hidden divergence, the price forms higher lows while the RSI forms lower lows, suggesting that the uptrend is likely to persist. Conversely, in a bearish hidden divergence, the price creates lower highs while the RSI forms higher highs, indicating that the downtrend is likely to continue. We will cycle back for more examples and information further ahead.

 

Bullish hidden divergence: In this scenario prices are setting higher lows but the RSI indicator shows lower lows therefore, we can see a confirmation of Bullish trend continuation as shown below figure 1.3.A.

Bearish hidden divergence: In this scenario price is pushing lower highs but the RSI indicator shows higher highs; therefore, we can see a confirmation of Bearish trend continuation as shown in figure 1.4.A

figure 1.4

Best Practices for RSI Divergence

1. Seek Confirmation through Multiple Pushes: The most reliable RSI divergence signals emerge after a triple upward or downward push. In this scenario, the first two pushes should occur in the overbought (above 70) or oversold (below 30) zones, with the third push falling between 30 and 70. If the price is setting higher highs (Bearish signal) or lower lows (Bullish signal), this configuration provides additional confirmation. Refer to Figure 1.3.

Figure 1.3

2. Incorporate Fibonacci Retracement Levels: An additional technique involves using Fibonacci retracement levels, specifically the 1.272 level, to evaluate the third price push. Apply Fibonacci to the last leg of the price movement and observe whether the price encounters resistance at this level. If divergence is also present in the RSI at this price point, it further substantiates your analysis. Refer to Figure 1.4.

Figure 1.4
This approach, known as the 3-Drive pattern, integrates price action, Fibonacci retracement, and RSI analysis. It is a highly reliable and effective strategy for traders. and provides them with great entries and good profits as well.

 

3. Mix RSI with your Trend lines: in this scenario we must draw our Trend line using magnet and our 2 points for the start of our trend line we must select the top or bottom of the shadow of a candle and another important aspect is if we want to draw a bullish trend line we have to have higher highs then we should wait for our 3rd impact with the trend line to execute our trade

Let's start with learning Correct way of drawing a trend line to use with RSI, as you we need to point to Draw a line as in trend lines there follows the same with some add-ons for correct trendline we must choose two proper points and using Magnet tool to select the exact top or bottom of a Candlestick’s Shadow as shown in figure 1.5

figure 1.5

 

Another important consideration in drawing a trend line is to check that you have a higher high than the first leg of your trend. In order to draw a trend line, you need to: 

1. Choose 2 points for drawing your trend line

2. You must have a higher high than your first leg for choosing your 2nd points as shown below in Figure 1.6

So you’re only allowed to draw a trend line if these 2 conditions have been met; otherwise, you are doing it all wrong and cannot use it with RSI.

The next phase is to wait for the 3rd impact with your trend line, here's where the magic happens with the help of RSI.

 

figure 1.7

 

As you can see after the 3rd impact price rose for over 60 pips so this is a nice strategy but as a nature of any financial markets there are times that price shows no respect to our trend line and smashes through it and there is nothing we can do about them just to accept our stop loss being triggered, Or Is It ?

Here comes our beloved RSI to rescue , you can get help from RSI if you draw the same trend line on your RSI indicator and watch the RSI reaction to your trend line this way you can have more certainty that if this trend line is going to work or not . RSI is an oscillator and some say oscillators have delay and are not reliable but a wise man called this strategy Tomorrow's Newspaper for a good reason and I'm going to show it right now .

Tomorrow's newspaper suggests that when you want to execute a trade on a trendline, draw the corresponding line on RSI as well and if Before reaches to your trendline, RSI has reached its trendline and breaks below it then you’re not allowed to trade that trend line. Take a look at figure 1.8: 

As you can see here, we have every requirement that we need to say that we have a good trendline and we should wait for the 3rd impact figure 1.9 

 

As you can see, price didn't care about our trend line and after the 3rd impact, price breaks our trendline and goes further below so how could we forecast this and prevent a loss? The answer is simple: RSI

Just draw the RSI trend line and you can see that before the price reaches its trendline RSI had already broken its line therefore we weren't allowed to execute this trade because RSI already told us that this trend line would break and won't work in our favor. 

figure 1.10

As you can see from the Red vertical line, RSI had already broken its trend line 13 bars before price reached its trend line so in a 15 minute time frame like 3 hours earlier RSI has told us that this trend line will break and we shouldnt trade on this level. 

Just to emphasize on the importance of this strategy i must say that RSI trendline and price trendline must be totally corresponding with one another; which means the exact candles that you have already chosen for your 1st and 2nd points for trend you must use a vertical line as well and chose those places on RSi as well and then using those point draw your RSI trendline .as shown on figure 1.11 

 

figure 1.11

4. Best There is: This Strategy has been developed by myself and never has been published or announced to the public so this is the first time i’m sharing this with anyone .

The concept of this strategy comes from Tomorrow’s newspaper. While I was watching for the 3rd impact, I noticed something very strange, and that was the trigger for developing this system. you see when there is failure on your trendline 3rd impact there is answer to that within RSI that RSI trendline has been broken before even price reaches its trendline so this means that out of x amount of position that your strategy is going to give you it will eliminate about 30% of them so is there way to get those trades back? 

When we have such a powerful tool (RSI) that can help us forecast the price movements, why shouldn’t we take a closer look at it?

Usually, when we draw a trendline on RSI we can see that RSI respects its trendline and has a great response to it. Let's take a deeper look into it: 

 

Figure 1.12 

Regardless of price Movements, you can use the same rules for drawing a trendline on RSI, which were: 

1. We need 2 points for drawing a line.

2. Before choosing our 2nd point, we must see a higher high.

So we just wait for our 3rd impact and as you can see in figure 1.12, it has worked nicely.

 

So with these explanations in mind, let's take a look at the price chart of figure 1.12 in figure 1.13. Drawbacks. 

figure 1.13

It is obvious that we cant draw a corresponding trend line on price because there is divergence happening in point 1 & 2 so in the price we see pushing lower lows but in RSI we see push forward higher lows, in other words we have downward trend in price but we have upward trend in RSI so there is no way to draw a corresponding trend line, but here's the interesting, point as you can see in figure 1.12 after the 3rd impact RSI move upward exponentially and as shown in figure 1.13 price has risen as well as RSI, corresponding huh? you might be wondering what just happened . fear not, there is another point of view on RSI which recommends that you can use dynamic and static Support/Resistance in RSI as well as price and candles after all RSI is a derivative of the price so anything that you can do with Price, in RSI is applicable as well. Static support and resistance are those that we use with horizontal lines or zones, and dynamic ones are trend lines, etc, which they represent in two dimensions.

If you pay more attention to RSI you can see even better results on trend lines than the price itself but it is worthless because we can not execute a trade based on RSI number , we need to find a correlation in them , and there is none until NOW .

 

Here comes the Strategy itself and explained for the first time ;

Idea is to find a way for perfect correlation and corresponding situation for RSI and price to find perfect entries, as you have learned from 3rd part of this article you can draw a line on price and then subsequently extend it to RSI but as discussed earlier we need to find different approach for transmission from RSI to price so we can find good entries.

First things first, we need to find a perfect trend line in our RSI and one that we can apply to the price, not like what happened in figure 1.13. in order to do that, we need to apply some filters for it : 

1. There must be no kind of Divergence between price and RSI.

2. For the price trendline we must exactly extend the exact point of RSI and don't think about the place that we see on price as well.

3. Once again for upward trendline, we must pick the exact bottom of the candlestick 

4. After extracting our first and second points from RSI and extending it to price then we are allowed to draw trendline on price using those 2 points no matter how much ugly or wrong it could seem , after all we want to find exact price for our 3rd impact of RSI trendline on price and nothing more .

To summarize it all together it's best to rehearse it all in one example and the see the use case of this last strategy

figure 1.14

In figure 1.14 we can see that we have a trendline that didn’t worked in our favor and price never reached it for 3rd impact to start the uptrend movement and price has went up and we just watched it and didn’t  do anything. 

figure 1.15

As it is obvious, RSI had already told us that we shouldn’t execute a trade based on the 3rd impact of price and trendline.

Here comes the Perfect trendline : 

We first choose the lowest point on the RSI trend line and extend it with a vertical line to the prices to find the exact candlestick that made that low in RSI (NOT the lowest Price) Figure 1.16

So now that we have chosen these 2 candles exactly extracted from RSI ( 2 candles are shown in figure 1.17 in red Ellipses )figure 1.17

Next we need to draw a trendline using the lows of these Candles (magnet)

Figure 1.18 

As is obvious in figure 1.18 you can see the price respected our extracted Trendline and at the 3rd impact it has just moved to the moon.

 

Version: July 2024