This the part II of this articles series. In the first article, we studied how to use the RSI indicator to take trades in a sideways ranging market and now I will show you how to use the RSI indicator effectively in an uptrend. Before we move on, take a look at the first article to familiarize yourself with what we talked about in the first article. You can find it here (LINK).
For those that rather stay with this article, I will quickly recap some basics. Regardless of the indicator or indicator parameters, you are using what really counts is your view on the prevailing momentum. If you don’t know which direction the market is likely to go it is mighty difficult to trade profitably. Therefore, before you consider using the RSI, make sure you understand what the market is doing. If the market is ranging or trending is the primary question you have to answer. Only after you know what kind you are dealing with you know how to use the RSI indicator.
In a ranging market, you will need a very different set of rules than when trading in an uptrend. And, you will obviously need again different rules for trading in a down-trending market. Okay, let’s now take a look at how to trade with the RSI indicator when the market is trending higher.
The AUDUSD (1h) chart above shows how the market turns from a downtrend to an uptrend. First, there is a breakout from a bear channel and then the market creates a higher low. These are early signs of a market possibly reversing higher. However, only after we have evidence that the bulls are committed enough to move the market above a significant swing high we know that the chances are pretty good that the market is actually reversing the direction. This is when we get interested in the RSI indicator.
As I explained in the previous article on RSI, I like the indicator to be more sensitive than the standard 14 periods RSI. This is why i use a lookback period of 7 instead of 14. With this setting, the indicator moves further away from the 50 level (the blue dotted line) on each price swing. You should however experiment with several different lookback periods and choose the setting that makes the most sense to You!
When the market is trending higher we obviously look for buying opportunities. Therefore, we are not really interested in the indicator moving into the overbought area (above 70). Note that although the standard settings are 30 (oversold) and 70 (overbought) the threshold can be adjusted and again you should play with it to see if you can come up with settings that suit your style of trading better.
In the above chart, I have highlighted the bars during which the AUDUSD pair is, as per the RSI indicator, in the oversold territory. This is the time period when the RSI indicates a buying opportunity.
Sometimes the market isn’t volatile enough to move the indicator into the oversold area. This is when you have to make a judgement call on whether to take this as a good enough indication that the market is now oversold ‘enough’ to warrant a buy.
Then there are other times when RSI indicates that the market is oversold but it still continues lower. These are the situations where you need to apply your risk management strategy. Never trust the market (or yourself) enough to trade a) without protective stops or with such a large size that you really can’t afford the potential loss. More experienced traders know this, but newcomers might still have these strange misconceptions that they will be so exceptionally good that they don’t need to manage the risk. I can assure you with 20+ years of experience in the markets that these ‘natural talents’ will be soon weeded out by the market. They will give their money away to more experienced traders and have to find something else to do. You might know the old saying: When a man with money meets a man with experience, the man with the experience gets the money, and the man with the money gets the experience.
BUT you should consider yourself lucky even if you don’t have that much experience or money. TIOmarkets has made it possible that I am holding a free strategy workshop webinar every month in which I will teach you genuinely useful trading ideas and strategies. As covering all the aspects of trading with the RSI indicator is beyond the scope of this article I advise you to go to www.TIOmarkets.com/webinars and reserve your seat for the next free webinar. That’s where we can talk about the trade selection process, risk management, targets and any other trading topic you might be interested in.
To trade successfully with the RSI indicator in an uptrend market you need to follow a routine. Here’s again an example that helps you to decide what kind of trading routine works for you.
- Identify an up-trending market using eg. the principles described in this article.
- Define your maximum risk per trade.
- Decide how far from your entry price you will place your protective stop orders
- Once you have defined your maximum risk and stop distance from the entry you know the maximum position size. Write this down to stay disciplined.
- Prepare to trade long when RSI enters the oversold area
- Enter the trade using the position size written down in your plan.
- Set the stop at the distance determined earlier.
- Exit the trade when the RSI indicator enters the overbought zone.
It is important to remember that each indicator and strategy has its strengths and weaknesses and that Please remember that: Each indicator and strategy has its strengths and weaknesses and that losing trades are just part and parcel of the package called trading. You will have losing trades, there is no question about it. Therefore, you need to have a good understanding of how often you are likely to get stopped out and what is the relative size of your losing trades compared to your winning trades.
Therefore, it is highly important to test this strategy idea with historical data and then again with live markets using a demo account before considering trading real money with the strategy. This will help you gain confidence and avoid anxiety derived mistakes during drawdown periods.
Hope this helps!
Chief Market Analyst
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