How I Use The RSI To Time Reversals

by | Mar 31, 2020 | blog, Editorial | 0 comments

There is never a shortage of twists-and-turns in the markets. Almost every day there is something else that causes us to suddenly drop or launch higher.

Up or down, chances are trading off price action alone— is not enough to signal when the market is going to make its move.

Which is why many traders turn to signals that are generated from something other than price action…

And as the markets get difficult to trade, it’s even more important to have a view into what’s actually happening under the surface of every stock.

The indicator that traders turn to is called RSI indicator… and can be one of the most versatile indicators to use to measure momentum in the stock.

So we will cover how the RSI times the markets along with how to combine indicators to get a higher chance of placing a winning trade!

 

Relative Strength Indicator

 

The RSI, or Relative Strength Indicator was originally developed by J. Welles Wilder.

This indicator is a momentum oscillator that measures the magnitude of recent price changes to evaluate overbought or oversold conditions in the price of a stock.

For this example, we are going to assume the RSI is a 14 period.

Formula:

RSI ​= 100 − [100 / [1 + (Average loss / Average gain)​]]

The average gain or loss used in the calculation is the average percentage gain or losses during a look-back period.

For example, imagine the market closed higher seven out of the past 14 days with an average gain of 1%. The remaining seven days all closed lower with an average loss of -0.8%. The calculation for the first part of the RSI would look like the following expanded calculation:

RSI = 100 – [100 / [1 + (1%/14) / (0.8%/14)]] = 55.55

Now that we know the relative strength index formula let’s analyze how to use this powerful indicator.

Pro Tip: The default setting for RSI is a 14 period but I use a 2 period for quicker signals intraday.

Now- let’s take a look at exactly how this indicator works and alerted us to a short signal on the markets today.

Next…

RSI Trade Setup

 

The RSI provides several signals to traders, from overbought and oversold, to determining if the buyers or sellers are driving the price trend.

4 key signals from the RSI:

  • Value over 90 – overbought
  • Values under – oversold
  • Values increasing – increased buyers
  • Values decreasing – increased sellers

Each of the four key signals that can be extremely important when determining the trend or reversal of a stock.

In this example, let’s take a look at what happens to the SPY’s when the RSI has overbought values. 

 

Source: Thinkorswim

 

In this example, you can see the RSI traded over 90 into the overbought zone.

And once a stock is considered overbought by the RSI, there is a good chance that there would be a market reversal to follow.

But that is not always the case…

When it comes to trading the RSI, this oscillator is not strong enough to make a stock reverse its trend.

So that is why it’s best to combine indicators and find correlated signals to give conviction in the decision.

For example, combining RSI with resistance, or RSI with Bollinger Bands actually works better than the indicator by itself.  

 

Combining The RSI With Other Indicators

 


As you can see the RSI by itself can be a strong indicator to add to any price action analysis for identifying trades.

But when you combine additional indicators with the RSI, it actually generates even stronger signals for the trader to look for.

And this is exactly what happened right after the bell on the SPY to start the week.

The signal:

  • RSI signaled overbought on the SPY
  • SPY traded into key resistance levels 
  • SPY traded above the upper Bollinger Band levels.

Let’s take a look at the chart of this combined signal.

 

Source: Thinkorswim

 

Here’s what I saw on the SPY’s:

The signal:

  • RSI went above 90, signaling overbought stock
  • SPY traded into overnight resistance 
  • SPY traded above the upper Bollinger Bands 


So… after carefully looking over all three bearish signals, it was then I decided to trade put options on the SPYs..

The Trade of the Day alert:

And even though this was a short reversal since the markets are acting strong, it still produced a great opportunity to short the market.

Here’s a plot of the options you could have traded and caught this pop in the potion prices right after the open.

 

Source: Thinkorswim

 

And even though this was a short reversal since the markets are acting strong, it still produced a great opportunity to short the market.

Here’s a plot of the options you could have traded and caught this pop in the potion prices right after the open.

 

Source: Thinkorswim


And that would have got a trader 25% returns in only 10 minutes of the trading day.

 

Conclusion

 

Remember, there is no single “holy grail” indicator or strategy you can utilize in your trading.

Instead, it’s best to understand how technical analysis can help with your decision making and give you a better entry price with your trades.

And if you were able to quickly identify the RSI pattern you could have made huge profits trading the markets short!

5 Important Facts:

  • The RSI is a reversal and momentum indicator
  • RSI readings between 10 and 90 indicate a strong and healthy trend
  • Readings above 90 are considered bullish, and overbought
  • Readings below 10 are considered bearish, or oversold
  • The default period of the RSI is 14-period, but I use a 2-period


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