One of the most important lessons that I have learned in trading is:
You must make a trading strategy your own.
But how do you do that?
What's the process behind customizing a trading strategy to your unique personality? Should you create a trading system from scratch or build on something that someone else has created?
Well, we generally start out with something that a trader teaches because we feel secure in knowing that at least they are using it successfully.
That's great and I highly recommend it.
However, it can be easy to get caught up in thinking that this one trading method is the only trading method.
Far from it.
In fact, there can be dozens of ways to trade the same basic indicator or trading idea. So you owe it to yourself to explore a little and test different variations of the trading strategy you are learning.
Doing so can help you uncover a little wrinkle that can help you make your trading method profitable. The Relative Strength Index indicator is one of the most used indicators.
However, thinking that you already know everything about RSI Forex trading strategies can be a big mistake.
Therefore, in this post I'm going to show you seven different ways to trade, using the RSI indicator. If this is a method that you are currently trading or testing, then you might want to experiment with some of these methods.
To make things interesting, I'm also going to do a quick backtest on the commonly taught method, using the EURUSD daily chart. This will give you a baseline and help you understand how trading with the RSI could be improved.
1. Vanilla RSI
OK, if you aren't familiar with how the RSI is usually traded, I'll go over that real quick. The Relative Strength Index is a measurement of how strong or weak price currently is, compared to recent price action.
If you want the exact formula, you can Google it and find it somewhere else. I'm interested in showing you how to apply it and test it, not how to analyze every single detail about it.
There is a look back period, over which the RSI value is calculated. The default is 14 periods, but some people use custom periods.
When the RSI gets above 70, you sell. When it gets below 30, you buy. Usually you wait until price, starts to form a peak or bottom out, before you sell or buy.
Here is an ideal sell example.
Of course, not all trades work out this well.
If you are missing a lot of RSI trading strategy signals, be sure to check out our standard RSI alert indicator for MT4.
Backtesting Parameters
Alright, let's get into a backtest with the way that trading with this indicator is generally taught in books. Here's how we are going to test this method.
- $10K starting balance
- 1% risk on each trade
- One entry, one exit
- Stop above/below the top or bottom of current price action
- Profit target of 2X pips risk, or 2R
- No pyramiding, one position at a time
- Maximum 2 losing trades on one overbought/oversold signal
Backtesting Results
I used backtesting software to test this system. Over a 16 year testing period, from 2001 to 2016, this system only made 10.29%. The winning percentage was not very high, considering I was targeting only 2R.
Looking at the profit chart, it traded flat for a long time, before finally starting to make some profit at the end. So this test was not successful and is not worth trading live.
Possible Improvements
If I was going to do a version 2 for this test, I would test targeting 1R, instead of 2R. This will probably increase the win rate and the return of the system.
Another thing that I would test is possibly waiting for a second peak in overbought or oversold territory, before taking the trade. It seemed like the first trade was often stopped out, only to have the second or third setup work well.
So as you can see, backtesting saved us a lot of time, by showing us that this trading system is not viable. Imagine if you traded that for a year before you found out that it sucks.
Now let's move on to the next RSI trading strategy that people commonly use. I won't backtest this one, I'll leave that to you 🙂
2. RSI Divergence
Another way that you can use RSI is as a divergence indicator. This means that if you can spot RSI trending in the opposite direction of price, it is a possible signal that price it going to follow too.
Here's what I mean…
To trade RSI divergence, you would still look for an oversold or overbought situation. But at these extremes, you would also look for a second RSI valley or peak that is heading in the opposite direction from price.
So in the chart above, the blue line on the chart shows the two price peaks going higher, while the RSI peaks are going lower.
This signals a possible reversal to the uptrend.
As you can see, price does drop from this point, but depending on your profit target, it may not have been enough to hit your profit target.
Based on my testing, divergence usually gives you better results than the vanilla RSI method. But again, it all depends on your profit target and risk per trade.
There are at least two other divergences on this chart. Can you spot them?
3. RSI Exits
As you know, when you get into a big trend, RSI can stay overbought or oversold for a long time. This can lead to big losses if you continue to fight it and you don't have something like a 2-Strikes Rule.
So an alternative to entering a trade when RSI hits the signal level and starts to turn, is to enter the trade when RSI exits the signal level. This may mean that you catch the entry late, but it makes it much less likely that you will be fighting a big trend.
4. Larry Connors RSI 2
Now we get into a really customized version of a RSI trading technique. This is the RSI 2 strategy by Larry Connors. Basically, the RSI indicator is adjusted to a 2 period setting and the signal levels are moved to 95 and 5.
After that, we use a 200 EMA to determine if we should go long or short. Above the EMA is long, below is short.
When price hits a RSI trading signal level and is in the right position, with respect to the 200 EMA, then you take a trade. You exit when price closes above (for a long) or below (for a short) a 5 EMA.
All of the long signals are marked in the chart above, with red vertical lines. Obviously, this is a very short-term strategy.
Connors advises not using hard stop losses, but that should be OK. Since it is a short-term strategy, you will be watching it anyway.
Learn the complete strategy here. You can also see the results of a backtest here.
5. Adjust Signal Levels to 80/20
Some traders also use adjusted signal levels to filter out the noise. When you increase the signal levels to 80/20 or even 90/10, you will get fewer trades, but it is possible that they will be better signals because you only get signals that are at absolute extremes.
As you can see, even in a strong trend, you don't get a signal. Test this out and see how it works for you.
I've tested a few similar methods, but they never worked well for me. Maybe you can do better and figure out the best RSI trading strategy, with custom signal levels.
6. Midline Crosses
The previous RSI trading methods rely on price extremes to find potential trading ideas. Of course, trading at extremes can be a great way to get in for cheap.
However, you are also bucking the trend and that can mean that you will also get stopped out a lot. One way to possibly remedy this is to try to catch price when it actually turns around from its extreme point.
You try to catch the middle of the trade, instead of trying to catch the top or bottom. So you set your RSI levels both to 50, then enter a trade as price moves through the 50 level.
Here's an example of a good long signal.
7. Swing 5
Finally, you can enter the market when RSI shows you a significant pullback against a trend. This can give you a great opportunity to get in at a cheaper price and profit from the momentum.
I found this strategy on the Tradestation Blog. It says that it can be traded on stocks, but it's worth giving it a shot on FX too.
The ideas is that you buy when price pulls back to the 200 EMA, when RSI is at an opposite extreme. If price is above the 200 EMA, it is bullish.
There is a little more to it than that, so be sure to read this blog post to get the entire system. I haven't personally tested this method, but of all the RSI trading strategies on this page, this one makes the most sense to me.
Here is a good long example.
Conclusion
So I hope that these RSI ideas have given you a few things that you can test. Remember, there isn't just one way to trade the RSI.
You have to find the one that works best for you. But sometimes you just need a few ideas to get your creative juices flowing.
Hope that helps you find the best RSI trading strategy for you!
