Determining trends is one of the basic blocks of technical trading. As the saying goes, the trend is your friend. Trading without knowing what the prevailing trend is can prove to be disastrous. A simple way to define a trend is one where price makes higher lows and higher highs in an uptrend and when price makes lower lows and lower highs, it signifies a downtrend. However, determining trends depends on many factors, one of the most important and often a point of confusion is the time frame the trade is looking at. It is well possible to see an uptrend on a daily time frame, while the one-hour charts might show a downtrend.
In order to overcome this ‘trend paralysis‘ it is often advised that traders should identify the trend on higher time frame and trade in that direction. A simple way to determine trend (besides the highs and lows) is to plot a moving average. Most traders make use of a 200, 100 and 50 day moving average to determine the long term, medium and short term trend. This, despite the fact that moving averages are known to be lagging. But what if there was a way to determine trend based on price action and one that could be used to confirm the bias (for example in confluence with the moving averages?). To gain some insights into how the RSI indicator works, click here.
RSI as a Trend Tool
When using oscillators, they are best put to use during a ranging market. However, an exception to this statement is the Relative Strength Index or RSI for short. The RSI indicator tracks the closing price and thus plots based on gains and losses. In fact, if you switch your chart to a line chart, you will notice that the RSI exactly replicates the price on your charts, with the difference that the oscillator moves between fixed ranges of 0 and 100.
Most common literature on RSI often use the levels of 70 and 30, representing overbought and oversold levels. A simplest way to trade RSI as many texts mention is to sell at 70 and buy at 30. In other words, when RSI rises above 70 and drops back, it is indicative of weakness in price and thus a recommendation to sell and vice versa when RSI drops below 30 and reverses to close above 30. It doesn’t take a genius to quickly figure out that this is absolute crap and in fact when trading real time, you will often notice how RSI tends to remain in an overbought or oversold state for a prolonged period of time.
So how can this widely misinterpreted oscillator be used to determine trend?
The credit goes to Andrew Cardwell’s research into RSI, which has turned around this what could have been just another oscillator into something unique. Cardwell’s study of RSI postulates that the levels of 70 and 30 are infact wrong and instead recommends the use of 80, 60, 40 and 20.
The chart above shows the RSI configured based on Cardwell’s study.
Putting the RSI to work
The basic premise of using the four new levels of RSI is that they help in determining if the asset or security is in an uptrend or downtrend. In order to find this out, it is suggested that when RSI oscillates between 80 – 40, it represents and uptrend and when RSI oscillates between 60 – 20 it represents a downtrend. The charts below illustrate this statement.
RSI In an Uptrend
The chart below is an example of how RSI can be used to determine an uptrend. As previously mentioned, when RSI oscillates between 80 – 40, it represents an uptrend. In other words, during an uptrend, RSI often finds resistance at 80 and support at 40. However, note that this condition is not set in stone. As can be seen in the chart below, there are moments where RSI dropped below 40. But the fact that it managed to move up indicates some flexibility to be applied to this condition.
In some instances, one may also find RSI drop as low as 20 and quickly reverse, while continuing its uptrend and this is perfectly normal. As long at the level of 60 doesn’t act as a resistance when price rises from 20, the uptrend is valid.
RSI in a downtrend
The next chart below shows how RSI behaves when in a downtrend. Finding resistance and support at 60 and 20, as price continues its downtrend. Again, note that the levels of 60 – 20 are not to be seen as absolute levels. As can be seen in the chart below there have been times when RSI did push higher than 60. But notice how it quickly reversed back into the 60 – 20 zone.
In this chart, it is easy to notice how the levels have acted as support and resistance.
How can the RSI be used?
By now it should be obvious that the RSI with the new levels can be a powerful indicator to pick up pullbacks in a trend. In the next chart below, we highlighted the pullbacks in a downtrend (along with plotting a 200 SMA). Notice how RSI clearly shows the pullback in relation to price.
The circled areas show that while in a downtrend, the RSI managed to push higher than 60. But we know that the level of 60 acts as resistance and thus we look for RSI to drop back into the 60 – 20 zone. Once RSI drops, it indicates a retracement in the downtrend and thus offers a low risk high reward trading opportunity. The same concept holds true during an uptrend. Where, we look for RSI to drop below 40 and trade the pullback once RSI climbs back into the 80 – 40 zone.
The rectangled area marks an interesting scenario, which we will cover in our next article. For now, try using the RSI as mentioned with these new levels. It is sure to help you understand the underlying trend and also as a confirmation.