A Detailed Anatomy of a Top-Down Trend Trade Setup Using RSI With A Signal Line

PART 1: THE METHODOLOGICAL EXPLANATION

Welcome to this sixth monthly feature-length blog post sponsored by the Trendline Mastery home-study course and membership service, available exclusively from Forexmentor.

Our monthly dispatch for May was entitled “A Top-Down Trade Executed Solely on RSI Trend Line Analysis”. In that article, we demonstrated how the application of discretionary trend line analysis drawn on the RSI indicator could facilitate detection of a strong trending pair, as well as help one find setups and entry triggers, among other things.

This latest article has a similar topical focus and scope as the preceding one – using RSI in a top-down trend trading configuration – but differs by virtue of not specifically requiring the  application of trendline annotations on the indicator panel. (That said, trendline analysis applied to the price panel is always a good thing to reference when working with indicators, so we’ll keep that piece for this discussion).

If you’d like some useful additional background on this subject, I would heartily recommend that you check out either or both of my TrendTradeForex weekly blog posts dated June 28th, 2016 (“Two Really Handy Things You Can Do To Make The RSI Indicator Come Alive”) and July 6th, 2016  (“Using A RSI Crossover As An Entry Trigger To A Trend Trade”).  These posts will provide useful explanatory background that supplements the present discussion.

Now, to get good trend readings out of RSI but specifically without trendlines drawn on it, we’re going to alter the chart configuration slightly compared to what we presented in the last monthly review. Specifically, we’re going to add a 20-period Exponential Moving Average over top of RSI, serving the role of a “Signal” line similar to the 9-period EMA plotted atop MACD for its equivalent, or the 3-period EMA of Stochastics, which yields the so-called “%D” line on that particular indicator.

In any of these three applications, what we’re looking for is a “slower” lagging line which the main indicator plot – whether RSI, MACD or Stochastics – interacts with to convey a directional bias and/or momentum reading. For this discussion, we’ll obviously omit reference to MACD and Stochastics and focus exclusively on RSI. (It remains to be seen whether you will end up agreeing or not, but my extensive experience with all three of the above-mentioned indicators leads me to conclude that the RSI-to- Signal custom configuration is the easiest to work of the three, usually providing the timeliest and most accurate readings).

So let’s begin with a quick primer on how to work with this custom RSI configuration. First of all, you will need to plot RSI on all charts comprising the multi-timeframe template you work with for your own trading. Just go with the conventional 14-period setting, which is the default for RSI used in virtually all charting platforms. There’s really no benefit to be attained from tinkering with the indicator setting itself, so we’ll just leave it at 14. If you want to save time and effort when setting up this multi-timeframe configuration, simply set up the right display parameters for one chart timeframe first, and then look to use whatever chart duplication tools your chosen platform provides to simply copy the first as a second, then change its timeframe to the next lower in sequence, and so on until you’ve finished creating All views comprising the new template.

What you’ll need to do next is apply a 20-period Exponential Moving Average over top of the indicator. Just to be clear: this will need to be an EMA on the basis of RSI itself, not an EMA on price. If you work with a charting platform that specifically allows for application of one or more indicator overlays on top of another, it should be a straight-forward procedure; simply consult the user documentation for that platform for the specific steps involved. If, on the other hands, your charting platform of choice does not allow for custom indicator-on-indicator overlays, then unfortunately this concept won’t work for you, and the only solution would then be to simply switch charting platforms to something else that does.

Once you’ve applied the Signal Line overlay, you should have an indicator panel at bottom of your chart that looks something like the following (although please note that I have customized the display even further by removing the 30 and 70 lines which are often used as “oversold” and “overbought” levels,  rendered the Signal as a dashed line, and colour-coded both RSI and the Signal so that they paint-in red when trending down on current-over-last readings, and blue when trending up):

CHART EXAMPLE #1
Simple Demonstration of Customized RSI with Signal Configuration

What even a fairly cursory examination of this chart example should reveal is that, whereas RSI is often very “jittery” – blipping up and down as often as every single bar in succession over certain periods of time – and thus hard to make sense of in its own right, the application of a 20period EMA Signal line over top of it smoothes out a lot of the “noise” making clear readings easier to come by.

To formalize the method for reading RSI with a Signal line, we will want to defer to the following fairly mechanical formulae:

  1. If RSI is above an up-sloping Signal line on the current bar versus the last Close, then the trend reading on that timeframe is nominally UP.
  2. If RSI is below a down-sloping Signal line on the current bar versus the last Close, then the trend reading on that timeframe is nominally DOWN.

In Chart Example #1 above, the juncture labeled (1) represents a bearish RSI reading using this custom configuration, while the juncture labeled (2) represents a bullish one. Please take a moment to compare the visual elements of these readings to the formulae specified above.

All of the above noted, please keep in mind the following critically important caveat:

IMPORTANT NOTE: You would never judiciously assume that either of the above types of readings found on one chart timeframe at any given point in time constitutes an actionable trend trading bias, because doing so would violate the important tenet of Top-Down Analysis, which is required in order to be able to distinguish any indicator reading as being either “corrective” or “trending”. Furthermore, it is risky to defer to an indicator reading only; a far better approach is to corroborate that reading against one or more reliable components of Technical Analysis found on the price panel, including Trendline Analysis, Market Flow Analysis, horizontal Support/Resistance Analysis and/or Fibonacci-based Continuation Patterns. When one or more of these expressions of Technical Analysis are in agreement with the indicator reading (and vice versa), you know that either element is more believable.

So, now that we have the custom indicator format specified and know how to read it, the next step is to apply it in a multi-timeframe Top-Down configuration.

Most traders are already familiar with this format, but in case you’re still searching for a robust delineation of multiple timeframes that will allow you to do everything from Position Sizing all the way down to Scalping, and all trading time spans in between, then you might wish to consider the following: Monthly, Weekly, Daily, 4hr, 60m, 15m and 5m (in the event of an unusually fast moving, trending market, you could conceivably also incorporate a 1m chart, although its prudent usage requires a somewhat advanced facility with top-down trading).

Once we have our custom RSI configuration plotted on all of the above timeframes, we need to specify a one or more rules as to what constitutes a reasonably “strong” trend reading.  As we noted above, that will almost never happen in relation to an indicator reading found on just a single timeframe, except by pure luck.

If you’ve been exposed to my trend trading teachings for any period of time, you will know that I’m a big fan of the idea that a strong trend reading is one that is detectable on a bare minimum of three consecutive timeframes, so that when you drill down to a fourth timeframe, lower than the preceding three, and find a corrective setup on that timeframe which does not invalidate the trend readings on any one or more of the higher timeframes, then you’re generally good to go for a pending trade entry.

Now, that “three trending timeframes plus one lower drill-down” specification could conceivably be applied in various ways (think Monthly/Weekly/Daily/4hr, for example, versus 60m/15m/5m/1m). And the means by which it is applied could make the difference between a longer term Position Trade and a shorter term Day Trade which actually entails a trading bias that could conceivably be contrary to a trend reading on the highest timeframes. And keeping track of all those possible combinations and permutations could easily prove to be confusing; particularly to newer, developing traders who are still getting accustomed to Top-Down Trading.

So to keep things simple, we might want to defer to one monolithic definition that constitutes the strongest possible application of RSI top-down, for the purpose of identifying a strong, high-probability trend trade bias.  And that definition can be stated as follows:

» When RSI-to-Signal trend readings are in alignment on all of the Monthly down to 60m charts inclusive (a total of five consecutive timeframes), you have the strongest possible Top-Down trend reading. Plan to trend-trade only in that direction (if you trade against it, you are counter-trend scalping, which is not a style applicable to this approach).

The next step would be to corroborate that confluence of indicator readings with Technical Analysis tools as mentioned in the preceding paragraphs. We won’t get into a detailed exposition of how that works, as doing so would be well beyond the scope of this article. For simplicity sake, let’s assume that we will try to find trendline analysis in agreement with RSI readings on most (ideally all) timeframes as we delve into our mini-case study example coming up momentarily.

With the Top-Down indicator readings validated by Top-Down Technical Analysis, we’ll next want to drill down to any of the lower intraday timeframes (15m, 5m or 1m if used) for a corrective setup. That setup can be delineated by way of counter-trend indications yielded on the RSI panel itself (e.g. bullish RSI-to-Signal reading on the 15m chart against bearish readings still intact on all of the 60m and higher timeframes inclusive) and/or on technicals apparent on the price panel (e.g. bullish break of a prior Supply trendline on the 5m chart then resolving to a rising Demand trend line, against bearish readings on the higher timeframes).

Once price and/or RSI resolve to the higher level trend by way of either a trendline break (former) and/or RSI crossover through its Signal line (latter), specifically in the trending direction, then you have a potentially actionable trend-trade entry trigger.

PART 2: MINI-CASE STUDY EXAMPLE

For a real-world chart example that demonstrates all of the above example, let’s consider the following mini-case study example: AUD/NZD with a long bias on Thursday, July 14th, 2016. We’ll reference all of the Monthly down to 5m charts for the purposes of:

  1. Finding a Top-Down RSI-to-Signal trend reading (in this case, bullish).
  2. Corroborating the Top-Down RSI trend reading with chart technicals (in this example, bullish Demand trend lines and/or Fibonacci-based Uptrend Continuation patterns on at least several of the key timeframes).
  3. Finding a lower-level corrective setup on one of the lower timeframes (in this example, a corrective dip in the uptrend visible on the 60m chart, resolving upwards).
  4. Finding a low-level entry trigger (in this example, a bullish RSI crossover up and through its Signal line from below on the 5m chart).

We won’t extend the discussion even further by referencing issues of trade management or exit strategy; all we want to be able to do here is identify a strong trend reading, a logical setup, and a viable entry trigger that does not subject the trader to trigger of a stop-loss. While it is understandable that some may refer to this practice as “cherry picking”, that criticism can be neutralized by pointing out that whether cherry picked or not, this combination of technical factors represents a logical checklist of what you should be looking for in real-time, each and every time. If you can replicate the suite of technical factors underscoring this cherry-picked example for your own trades, the ensuing results should hopefully speak for themselves, over time. (That said, please try it in demo mode only until you have amassed enough experience and comfort with it).

So let’s dig in to this case-study example, starting logically from the highest timeframe (Monthly) and working our way down through each successive timeframe in sequence, culminating in an entry trigger found on the 5m chart.

CHART EXAMPLE #2
AUD/NZD Monthly Chart: Open for July, 2016

The dashed vertical line on the above chart is drawn through the Monthly bar for July, 2016, the Open on this timeframe as at the time a valid trend-trade long signal was triggered on the 5m chart for 22:15 GMT (10:15pm GMT or 6:15pm EDT) on Thursday, July 14th.  This particular chart view is the one that provides the least compelling trend reading, as RSI is just in the process of crossing up and through the Signal line from below, following completion of a downside retracement that dates all the way back to the SP High for August, 2015.  That said, the technical picture being more convincingly bullish on all the lower timeframes as we drill down, and a Fibonacci-based Uptrend Continuation pattern setup present on this timeframe (the corroborating technical element we want to apply in conjunction with RSI), is enough to conclude that the reading is likely bullish here, even if not convincingly so.

CHART EXAMPLE #3
AUD/NZD Weekly Chart: Open for July 11th, 2016

The dashed vertical line drawn on the above Weekly chart reflects the Open as at time of trade entry being the bar for the week starting July 11th, 2016.  This bar is self-evidently significant for the simple reason that it is achieving a Close above the Supply trend line (dashed diagonal annotation) drawn downwards from the SP High for April 25th, 2016. Anywhere above the trendline intersection point of 1.0470 on a strong green body, it was apparent that a bullish break was in the process of occurring, which aligns with the larger-scale Continuation Pattern shown on the Monthly.  And as that occurs, we see RSI punching up above its Signal line from below. So, here too, we see the complementary roles served by indicator readings and Technical Analysis on the price panel.

CHART EXAMPLE #4
AUD/NZD Daily Chart: Open for July 14th, 2016

On the Daily chart shown above, we denote the live bar for this timeframe at the point of trade entry with a dashed vertical line through the time coordinate of Thursday, July 14th, 2016.  During this session, as price closes above the intersection point of the Supply trend line (formatted with a dashed line) at just a few pips above the 1.0500 handle, a bullish trend line break appears to be occurring. At the same time, it is possible to anticipate a new Demand trendline forming (drawn upwards from the SP Low for July 8th), which also suggests a trend reversal, from down to up. We can also see at this juncture that after RSI had crossed above the Signal line on the Daily bar Close for July 11th, it kept waving higher above a persistently up-sloping Signal reading to and through July 14th.  All of these factors are compellingly bullish at this point, and they agree with the trend analysis to be found on the higher timeframes.

CHART EXAMPLE #5
AUD/NZD 4hr Chart: Open for 7/14/20:00 GMT

As we drill down to the 4hr chart, we can see that the dashed vertical line drawn through 8pm GMT (4pm EDT) bar for Thursday, July 14th, 2016 represents a juncture where we have both a strong and intact Demand trendline drawn on the price panel, nicely corroborating that bullish RSI-to-Signal line reading seen also at that point. Though we didn’t specifically capture it on this timeframe, the Demand trendline in question also happens to reflect a progression of higher highs and lows on the major swings, i.e. Bullish Market Flow.

CHART EXAMPLE #6
AUD/NZD 60m Chart: Open for 7/14/22:00 GMT

Drilling down further, to the 60m chart, the vertical timestamp of 10pm GMT on July 14th reflects two elements of interest: 1) The dashed diagonal line conveys a counter-trend Supply trendline, which in turn forms the corrective setup that we’re always on the hunt for to get into a trend-trade (the proverbial “dip in the uptrend” in this example); and 2) As price opens and closes above the Supply trendline noted – resulting in a valid trendline break – RSI crosses up and through the Signal line from below.  At this point, we have satisfaction of the criteria we mentioned in one of the preceding paragraphs in terms of a strong Top-Down trend integrating all of the Monthly down to 60m charts inclusive.

CHART EXAMPLE #7
AUD/NZD 15m Chart: Open for 7/14/22:15 GMT

We’re getting closer at this point to an entry trigger: As we drill down still further, we see a bullish RSI trend reading on the Open bar for 10:15pm GMT (6:15pm EDT).  On this timeframe, there isn’t really much else to latch onto, in terms of corroborating Technical Analysis. Then again, there’s nothing about this timeframe that screams “downtrend” either, so given the fact that chart metrics are so clear and consistent among all of the other timeframes we’ve looked at thus far, we’ll simply hold our collective noses over the lack of corroborating evidence on the 15m chart. And that’s not an atypical scenario either: While it’s nice to see all timeframes line up in like fashion in real-time, often there are one or maybe two holdouts requiring a discretionary attitude as to whether that matters or not.

CHART EXAMPLE #8
AUD/NZD 5m Chart: Open for 7/14/22:15 GMT

Finally, we drill down to the 5m chart, looking for a pending entry signal. As RSI crosses above the Signal line from below (indicating that price may be resoling to the uptrend following the preceding counter-trend bearish reading on RSI) on the close for 22:10GMT, we have that entry trigger. That means we’re good to go, entering long on the open of the very next candle, 22:15 GMT. To make the decision that much easier, we have a Demand trendline intact on this timeframe at the point of entry, with multiple recent touch points on the trendline indicating support, and allowing price to therefore travel higher.  The entry price is 1.0606 (not factoring in dealing spread), and the lowest low from there onwards is 1 pip, before the point is reached where sufficient floating profit allows for the Initial Protective Stop to be trailed to breakeven.  Again, we’ll ignore issues of exit strategy and trade management for the purposes of this illustration; suffice to say that, regardless of trading style employed, no trader executing on this setup would have withstood a worse outcome than a slight diminution of floating profit over the ensuing two daily trading sessions, before price went on to make still higher highs.  Not even a breakeven stop was a possibility through the close of the following Monday session.

And that’s it!

CONCLUDING COMMENTS

In this case study example, we see how the RSI-with-Signal configuration provides reasonably strong and clear trend readings when amplified across multiple timeframes at once, particularly when married together with corroborating Technical Analysis, whether that be designated to include Trendline Analysis, Market Flow, Fibonacci measures, horizontal Support/Resistance, or any combinations thereof.  We also saw how a counter-trend event of some kind on one or more of the lower timeframes, which was not sufficient to reverse the trend reading on any higher timeframe, provided a good cue to expect a pending breakout move in alignment with the prevailing trend. Finally, where RSI made first a counter-trend crossover then a trend-aligned crossover (up and through its Signal line from below) on one of the lowest timeframes, we had a good entry trigger.

Well, that takes us to the end of this feature-length Monthly Blog Article for July. I hope you’ve enjoyed it and found it informative. Please feel free to respond to it with whatever feedback or questions you may have on this topic using the Comments feature shown below. And if you really liked it and want your trading peers to be aware of it, we would greatly appreciate your taking the time to share it online or provide inbound links in any other fashion.

We look forward to seeing you for our next monthly feature-length Blog article, scheduled for late August. Of course, we’ll let you know when that piece is available.  Thanks for joining us here today.

Good Trading!

Frank Paul

Frank Paul at Forexmentor.com

Frank Paul at Forexmentor.com

I am well known for my ability to deliver clear and concise explanations of complex trading topics.   I am the force behind a series of comprehensive, yet practical, forex courses and training programs at Forexmentor.  (Forexmentor links to www.ForexMentor.com.)

“…purchased at least two of your courses and I must say that I greatly appreciate your methodology and willingness to share with others. One of the things I appreciate most about you is that you are not like some of those money grabbers out there who is so quick to sell you a system for huge bucks. I believe you are a very genuine person who would want to see me or anybody succeed in their Forex Trading career. Thanks again, Omar.”

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