#8: RSI Indicator Secrets
Hey, hey, what's up my friend?
In today's video, I’ll be discussing the RSI indicator also known as the Relative Strength Index.
Here’s what you’ll learn today:
- The truth about the RSI indicator and why it's not just about overbought or oversold
- How to increase the probability of your winning trade using this one simple technique (that I've never seen anyone talk about)
- The best market to use the RSI indicator since not all markets are created equal, some of them are very suited to apply the RSI indicator due to the characteristic of the market (I'll share with you which market it is)
- How to time your entries with precision
- How to time your exits before the market reverses against you
Let's get started...
The truth about RSI indicator
RSI stands for Relative Strength Index and it's an indicator, a momentum oscillator developed by J. Wilder. This is a momentum indicator, so let me prove it to you.
This is the breakdown of the RSI formula:
Don't be alarmed by it. I know you're thinking:
“Oh man, Rayner I suck at math, why did you show this to me?”
Don't worry this is very simple to understand, even a 10-year-old can do it.
Let me walk you through step by step and explain to you why the RSI indicator is a momentum indicator. Then we’ll look at how you can use this indicator for your own trading.
Looking at the formula, the first question is what is the average gain? Let me give you a very simple example.
Let's use a 10-period RSI to make things simple. You're essentially calculating the average gain over the last 10 periods or over the last 10 days if you’re trading on a Daily chart.
Let's say a stock moves $100 over the last 10 days the average gain of a stock is $10. You’ll just take $100 divided by 10 days because we’re using a 10-period RSI.
And the average loss is just the same thing. You’ll compute the total loss over a given period and divide by the number of periods. That's your average loss.
The key thing to take note is that the higher your average gain, the higher your RSI is going to be. Make sense?
Let's take for example:
- Average gain = $10
- Average loss = $1
Taking $10 divided by $1 your RS equals 10. Put the values into the formula and you’ll get RSI of about 91. It's showing you strong momentum because your average gain is much higher than your average loss. Can you see how this works?
Let's say this time around…
- Average gain = $10
- Average loss = $20
$10 divided by $20 is 0.5. Pluck in the numbers and you’ll get RSI value of 33.34. The reason for this is because the average loss is greater than the average gain. There's more bearish momentum in the market, that's why your RSI value has fallen.
Can you see how this RSI formula works? It's nothing scary. It's actually relatively simple. And let me just break it down for you.
RSI goes up:
RSI goes down:
When your average gains are smaller than your average loss. This means the size of bearish candles is larger than the bullish candles. In other words, the RSI indicator measures momentum in the market.
(Disclaimer: I used a very simplified version of calculation for the RSI indicator, I think their calculation used is a little bit more complicated with exponential involved. But again, the concept is the same. It's just that the way they calculate it is more complicated.)
Now that you know how RSI works, why it goes up and why it goes down, how can you use it in your training?
Let's move on and find out...
How to improve your win rate
You can use the RSI indicator to improve your winning rate by trading with the trend.
It’s no surprise that when you trade with the trend you get a larger profit potential because the trending move of the market, which is the stronger leg of the market, usually moves more compared to the pullback.
On top of it, when you trade with the trend, the market tends to persist in that same direction when it's trending. When you're on the side of the trend, your win rate naturally goes up as well.
But now the question is, how would you define the trend? There are many ways to do it. Some traders talk about higher highs and higher lows, lower highs, and lower lows, but that’s a little bit subjective.
What I'm going to share with you is a very objective way to define the trend using the RSI indicator. It's something that, I've never seen anyone talk about before.
If you recall, RSI is all about measuring your average gain to average loss. If you think about this:
- If the average gain is greater than the average loss, the market is essentially in an uptrend
- If the average gain is smaller than the average loss, then the market is in a downtrend
Here's something to share with you...
I’ll be using a 250-period RSI since there are 250 trading days in a year. Instead of 250, if you only use 200 it's fine, it's up to you.
If RSI above 50:
This tells you is that the average gain is larger than the average loss, you can conclude that it's in an uptrend and you wanna buy look for buying opportunities.
If RSI below 50:
This tells you that the average loss is greater than the average gain, and you can conclude that it's in a downtrend and you want to look for selling opportunities.
If you look at this, I have drawn this blue line over here at the RSI = 50 marks:
Every time the market is above this blue line, you can see that it's in a long-term uptrend. And every time the market is below this blue line, you can conclude that it's in a long-term downtrend.
If you look at it this market, when the market went above this blue line the market is pretty in a very nicer uptrend because the average gain is greater than the average loss:
And likewise, if you just zoom back out a little bit, you can see that over here when the market traded below the blue line, it's telling you that the average loss is greater than average gain.
So you can use the RSI indicator to help you, to define the long-term trend using the technique that I just shared with you. It's very objective. You don't have to guess if it’s a higher high or a higher lower, etc.
Just use this to plot out the 50 marks on the RSI indicator, anything above it is a long-term uptrend. Anything below it is a long-term downtrend.
Then you can just trade in the direction of the trend symbol. That's the first trading technique that I want to share with you.
The best market for the RSI indicator
I've done quite a bit of research on this and I found out that the stock market works really well for the RSI indicator.
There's a reason for it:
The stock market is in a long-term uptrend
If you look at any stock markets, the S&P, the NASDAQ, the Russell, or whichever country you're from, you’ll see there's a very high chance that the market is probably higher than it is since inception.
It’s because economies grow, GDPs increase, and countries do well. The stock market is a barometer, it’s a reflection of the economy. That's why it's in an uptrend. And one thing about the stock market is that the pullbacks are usually short-lived.
Yes, the pullbacks can be pretty strong at times and the sell-off can be really quick. But it's only a matter of time before the pullback ends, and then the trend resumes itself.
Since you know that pullbacks are usually short-lived in the stock markets, you can use the RSI indicator to time the “extreme pessimism” of the pullback. And that’s usually a pretty good time to be looking for buying opportunities.
Because the stock markets, in the long run, are in a long-term uptrend. The RSI indicator is very useful to help you time your entries on these pullbacks.
You’re looking to buy during this “extreme pessimism” where traders, investors are panicking and are selling their holdings. That's where you want to come in to buy and to be a contrarian.
How to time your entries with precision
I use a 10-period RSI, which is about two weeks of price action data. If you're gonna use 14-period, 15-period, it's up to you. It's not going to make much of a difference.
You want to look to buy when RSI is below 30. I'm not saying buy when RSI is below 30, but look to buy when RSI is below 30.
Because remember when the RSI value goes down lower, there’s a stronger bearish momentum in the markets as the average loss is much larger than the average gain.
When RSI is below 30 it's telling you that there is strong bearish momentum in the market. And as you know, pullbacks are usually short-lived, it doesn't go down forever.
Yes, there are times the market goes into recession, the stock market is in a downtrend, but it doesn't happen often, maybe once every 10 years.
And just because the RSI is below 30 doesn't mean you want to buy because you still want to wait for confirmation that the buyers are stepping in before you enter the trade.
You don’t want to jump the gun too early and then swallow the pullback as the market goes against you. You can consider entering your trade after the price has broken the previous day high, maybe using a buy stop order.
Or you can wait for a bullish reversal candlestick pattern before you enter a trade
Let's have a look at the S&P500, and I'm going to use the 10-period RSI.
I'm just going to zoom out a little bit and highlight to you the times when the RSI dips below 30. You can see that it doesn't happen often, but when the RSI goes below 30, the stock market would make a bounce higher:
As I mentioned, whenever the RSI is below 30 it's a sign to you that the market is a staging steep pullback and the last thing that you want to do is to go short.
Because the market is in a long-term uptrend, shorting when RSI is below 30 is usually a bad idea. You want to look for buy opportunities instead. But as I've mentioned earlier, you don't want to just blindly buy.
When the RSI is below 30, you can see there are times where you would have to really swallow this huge reversal against you:
Usually, I’ll recommend to let the market show you its hand, to let it rally higher before you enter the trade. And one technique that I can share with you is to use a buy stop order above the previous high to get on board the trade.
The market breaks above this previous day and your stop loss can go below this swing low and you would have caught this huge reversal up higher. That's what I mean by having a buy stop order above the previous day high.
Here’s another example…
The market at the first point also had its RSI below 30, but it turned out to be a losing trade where the market rallied a little bit before it reversed lower.
At next point, the RSI is below 30 and when you placed the buy stop order above the previous day high, you would've caught the move up higher
Do the backtest, don't just take my word for it. Validate the concepts that I’ve just shared with you and see whether it works for you or not.
But a key idea here is, in the stock markets, the RSI indicator works well based on my own research.
So you’ll look for buying opportunities when RSI is below 30. You can either:
- Wait for the price to break out of the previous day high using a buy stop order
- Wait for a bullish reversal candlestick pattern before you time your entry
Now, you don't want to do this across every market because not all markets behave the same. The stock market is a different beast. It's in a long-term uptrend and the pullbacks tend to be short-lived before the trend resumes.
If you apply these other types of markets, like maybe GBP/JPY and if you just buy just because RSI is below 30, you’re going to suffer quite a bit.
You can see that GBP/JPY can remain oversold for a long period of time too:
So don't just blindly buy when RSI is below 30 and don’t just blindly sell with RSI is above 70. Because the RSI is only a momentum indicator.
And the reason why I talk about the stock markets it's because the stock market is a different beast. Its pullbacks tend to be short-lived before the trend resumes itself. The RSI is great to identify this “maximum pessimism” to time your entries.
How to better time your exits
For many traders, the market goes in their favor but the next thing is the market reverses and hits their stop loss. Why is that?
What you can do is you can look to capture a swing in the market and exit the trade, you don't try to ride the trend. So that’s called swing trading. And the RSI indicator can help you with it.
For example, let's say you’re long, you can exit when the RSI crosses above 60. This means that the average gains are larger than the average loss.
The market has made a swing so you’ll exit the trade after one bullish swing.
If you’re short, you can look to exit when the RSI crosses below 40 you exit your trade when the market makes just one down move.
For GBP/JPY, let’s say you went short at this price rejection and you exit your trade when the RSI crosses below 40:
So you’re just capturing this one swing over there.
Let’s say you went long on crude oil at support, you can exit your trade when RSI crosses above 60:
Again you’re just capturing this one swing in the market.
This is how you can use RSI to help you capture a swing in the market, otherwise known as swing trading.
- RSI measures momentum in the markets
- You can use RSI to trade with the trend – above 50 for buying opportunities, below 50 for selling opportunities
- RSI works well in the stock markets to help you time your entries on a pullback
- RSI can help you capture a swing in the markets