Forex Countertrend Trading With The RSI Oscillator
Forex trading strategies are often as unique as the people that employ them. Retail forex traders come from a variety of backgrounds where different ideas and theories may hold more importance than others. A person experienced with trading stocks may have a very different view on how to be successful in forex than a person with no trading experience at all. Personal differences aside, there are many unifying factors that bind traders together in our pursuit of profit. Concepts such as risk and money management are of great importance to every trader.
Trading strategies, such as this simple RSI strategy, often come down to personal preference. Some people like complex strategies while others prefer to keep things simple. There is only one truly right answer when it comes to personal preferences in trading- "Is it profitable for me?" What works for you may not work well for the next trader and vice versa.
This strategy is more on the simple side of the spectrum. It combines principles of Price Action and the Relative Strength Index (RSI) oscillator that can be applied on any chart of 5-minute increment or greater. The goal is to take advantage of pristine Reversal set ups as they emerge to ride the waves of the forex market to profitability.
- Versatile system that can work well on most time frames.
- Simple with clear market definition of Stop Loss and Take Profit placement.
- Can be used in a trending or range-bound market (though range-bound markets may afford fewer opportunities).
- Best used on Major pairs that feature clear volatility and low spread. Suggest EURUSD for Scalping.
- Not appropriate for Continuation signal trading.
- Not usable in a choppy market. A range-bound market should be clearly defined by the price action.
*Relative Strength Index (RSI)
The RSI is a momentum indicator that compares gains and losses of a currency pair to provide insight on an over-bought state, over-sold state, or immediate trend strength. The suggested period setting for RSI is 14. The indicator will then look at the past 14 periods, apply that information through a formula, and plot the result on a chart ranging from 0 to 100.
A 0 would indicate the past 14 periods had all closed lower- there were no gains to aggregate and plot. A 100 indicates all 14 periods closed higher.
In most cases, the point will range from 0 to 100 rather than reach these extremes. The information RSI provides can be used as one part of an entry or exit strategy.
A value of 70 and over indicates a potential over-bought state while 30 and under is over-sold. When the indicator crosses these values, we can conclude there may be a potential reversal on the horizon. Price never moves in a linear direction for long so we use the 70/30 levels to identify when a currency pair is reaching extremes. Greater discretion can be had by using the 80/20 levels instead.
Unfortunately, RSI cannot be used by itself effectively. It simply does not provide an accurate view on its own. The problem is that it can easily throw false signals if there are multiple candlesticks of activity generated by a temporary circumstance- like a news event. Thus, we need to implement an additional means of screening signals that are hinted at by the RSI oscillator.
An integral part of the equation for identifying strong reversal signals is the candlestick pattern. Just about any reversal candlestick pattern can be used to identify a potential trade. The strongest reversal signal is the pin-bar. Scalpers and day traders will likely want to stick solely with the pin-bar as it is such a pronounced, strong signal that provides plenty of room to make profit before price hits the target. Engulfing bars can be used but you will find less opportunities that have the potential to give you a suitable reward for your risk.
Stop Loss and Take Profit
Every forex trade should incorporate a Stop Loss that you are well aware of before you ever execute. The Stop Loss should be placed just behind the candlestick pattern that served as your entry signal. The aggressive Stop Loss reflects the volatile nature of corrections. It should not take long before price reverses and heads towards profit if it is going that way.
The Take Profit for this system is placed at 50% of the movement that led to the reversal signal so long as it is at least a risk to reward ratio of 1:1. Any less than that and you should pass on that particular set up. If you want, you can use Fibonacci Retracement to find the 50% mark but you should be able to estimate the distance by just looking at the previous price movement.
Applying the Strategy
The simplest way to make execution decisions with technical analysis is to use an analytical process. A checklist works wonderfully!
*Trading A Reversal
1. Has the RSI broken the 70/30 mark? If yes, inspect the chart to confirm a relatively smooth climb/descent in the pair's price leading up to this point. If both points are confirmed, continue to #2.
2. Has a clear, pristine Reversal candlestick pattern printed? If yes, continue to #3. If no, WAIT until one prints.
3. Calculate the number of pips between your potential entry and the location of your Stop Loss. Then, find the 50% point of the previous price movement leading up to the Reversal pattern and calculate the number of potential pips you can take. If the return is at least 1:1, continue to #4.
4. Execute the trade if all three of the previous points line up perfectly. If they do not line up, then you are in a suboptimal set up and have a higher risk of loss.
This trading strategy assumes you will be entering to profit from pullbacks in a dominant trend. It is not particularly suitable for with the trend trading due to the way RSI works. There is likely to be more candlesticks of the dominant trend in the past 14 periods that RSI aggregates making it very difficult to print a with trend over-bought/sold condition.
The time period you trade on will affect your entry decisions. Be wary of economic events. They can easily knock you out of a position through erratic movements.
There are different times in this strategy that "clear" or "pristine" signals are mentioned. It is very important to look for the best signals to trade. The clearer it is, the more likely that other traders will see it and help the signal fulfill itself. If you have to spend a lot of time wondering about whether or not it's a good signal- it's not. Scalpers and day traders must be extra vigilant in screening signals. The lower time frames use less information and can easily be tilted in the opposite direction.
Trading Reversals often deals with a fair amount of volatility and clear movement. Conservative traders may want to implement a timed stop on their position. A good rule is "If price does not begin to cleanly move in my profitable direction within two periods, I will exit the trade." The thinking is that if the volatility were there for the Reversal, it would manifest within two periods after a clear pattern had printed. You can see this for yourself by looking through price history.
Suggesting Additional Reading
A successful trader is one that never stops learning. This strategy article was meant to give you a solid foundation but there are plenty of points that are outside the scope of it. For further study, you should look into:
- RSI Oscillator
- Candlestick Reversal Patterns (Pin-Bar and Engulfing)
- Range Bound Forex Trading
- Support and Resistance Levels
- Risk Management
This post was written by Daniel Lindsay. You can follow him on Google +. Daniel’s other blog posts on MahiFX can be found here.
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