Another Way You Can Customize RSI To Assist With Top-Down Trendline Analysis

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Welcome to the August, 2016 monthly blog post sponsored by the Trendline Mastery home-study course and membership service, available exclusively from www.forexmentor.com. We hope you’ve had the chance to read some (or all) of our prior articles, and have found them useful and instructive.

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In two of our prior monthly blog posts, we introduced the RSI indicator (Relative Strength Index) as a particularly effective and applicable technical tool to assist with the kind of Top-Down Trend Line Analysis that is explained in the Trendline Mastery foundation course.

In our May installment, we demonstrated how it is possible to draw trend lines directly on the RSI indicator plot itself, which can be useful to the extent that doing so occasionally reveals trend and Support/Resistance readings that might not be apparent on the price panel itself. Last month, we demonstrated how the overlay of a 20-period Exponential Moving Average (EMA) line on the RSI panel can serve as an effective Signal line akin to that used in standard MACD formats, the %D line on a conventional Stochastics plot, and so on.

What I’d like to do this month is continue our investigation of the various ways that RSI can be of assistance with trend trading in general and with trend line analysis in particular, by specifying another helpful alternative display format you can use with this indicator.

First Step: Doing The Format Tweak

To configure RSI in the fashion that we are going to spend the rest of this article explaining, you will want to undertake the following customizations:

  1. Using the indicator formatting options available with most popular charting platforms, insert a horizontal line equal to a value of exactly 50.0. We are typically going to interpret RSI readings of below 50 as bearish, and above 50 as bullish (lots more on that point in the paragraphs that follow…)
  2. Remove (or render invisible) the conventional “Overbought” reference line of 70 and the corresponding “Oversold” reference line of 30 from the RSI panel. These values have no special significance in the custom configuration we’re going to use here, so we can simply get rid of them altogether.
  3. Optional: If the charting platform you are working with specifically enables color coding for bullish or bearish readings on an indicator (the ProRealTime platform I personally work with does), you might want to think about color coding RSI readings of below 50 a shade that conveys bearishness to you, and conversely readings above 50 as bullish. If you cannot color code these custom RSI readings, you will simply have to “eyeball” RSI in relation to the midline of 50.
  4. Optional: Another useful format tweak you might want to consider (again, if the charting package you prefer allows it) is to color code readings on the RSI line itself such that a down tick paints in a bearish color (e.g. red), and an uptick paints in a bullish color (e.g. blue).

With all of the above format customizations made, your RSI chart output should end up looking something like the following extract:

Exhibit 1: Sample RSI Plot with Midline and Bullish/Bearish Color Coding

If you are a multi-timeframe focused trader like I am, you will definitely want to replicate this indicator configuration across all of the chart timeframes you include in your own personal charting template. For me, that means Monthly down to 5m inclusive.

Second Step: Deriving Trend Readings from this Configuration

We all know that RSI is a relatively jittery, “noisy” indicator. There’s no question about that. And that is why, using the conventional format and interpretive rules specified elsewhere, I think a trader can easily end up feeling confused by its readings.

But with the format customizations specified above, it is actually possible to put the blips and bleeps RSI generates all day long (at least on the lower timeframes) into an intelligible context. The really neat thing about this approach, is that RSI can actually generate a primary trend reading, as well as a corrective trend reading at the very same instant. In other words, there are two components of reading RSI with this method, as follows:

Bullish RSI Readings

If RSI is above the 50 line, the generic trend reading on that timeframe is bullish.

  • Scenario #1: If RSI is ticking up on the current bar compared to the last bar (above a value of 50), then real-time momentum is in agreement with the predominant trend. This is a fully bullish reading. If you’re using the two color coding options suggested above, then the RSI panel spanning the interval above the midline will be painting in blue (or whatever other color you designate for this purpose), as will the RSI line plot itself.
  • Scenario #2: If RSI is ticking down on the current bar compared to the last bar (again, specifically above a value of 50), then real-time momentum is running counter-trend to the predominant trend. This is a bullish reading with possible correction or retracement unfolding in the downwards direction. If you’re using the two color coding options suggested above, then the RSI panel spanning the interval above the midline will be painting in blue, but the RSI line plot itself will paint in red. In most cases, we should assume that when the RSI line gets back into agreement with the primary trend reading, then a bullish continuation move may be unfolding.

Bearish RSI Readings

If RSI is below the 50 line, the generic trend reading on that timeframe is bearish.

  • Scenario #3: If RSI is ticking down on the current bar compared to the last bar (below a value of 50), then real-time momentum is in agreement with the predominant trend. This is a fully bearish reading. If you’re using the two color coding options suggested above, then the RSI panel spanning the interval above the midline will be painting in red, as will the RSI line plot itself.
  • Scenario #4: If RSI is ticking up on the current bar compared to the last bar (again, specifically below a value of 50), then the real-time momentum is running counter-trend to the predominant trend. This is a bearish reading with possible correction or retracement unfolding in the upwards direction. If you’re using the two color coding options suggested above, then the RSI panel spanning the interval above the midline will be painting in red, but the RSI line plot itself will paint in blue. In most cases, we should assume that when the RSI line gets back into agreement with the primary trend reading, then a bearish continuation move may be unfolding.

Please bear in mind that the above noted interpretive rules are like anything else in trading: Most of the time they work generally well (particularly if aligning in top-down fashion in real-time; more on that in just a moment), but they can’t be expected to work well 100% of the time without question. Certain types of market profiles can wreak havoc on indicators; most particularly choppy and rangebound markets, not to mention the kinds of not-specifically-anticipated massive breakout moves that can occur in response to market moving news events. So please do the right thing by not assuming that what we are presenting to you here constitutes any kind of holy grail.  A smart trader will always be cautiously optimistic when responding to a new idea that seems to have potential merit, but tempering that optimism with a cautious and skeptical attitude until such time as he has worked with it extensively and gotten used to its strengths and vulnerabilities.

In any event, the four types of readings of the customized RSI plot as referenced in the four preceding bullet points are depicted at various junctures in the following chart extract:

Exhibit 2: Sample RSI Trend and Momentum Readings

Third Step: Lining Up the Readings With Top-Down Trendline Analysis

If you’ll recall the special “formula” we consistently reference in the Forecast Pack reports published twice weekly in the Trendline Mastery Trader’s Club, you’ll know that a strong and reliable trending market can typically be defined as showing the same bias of Trend Line Analysis on all of the Monthly, Weekly, Daily and 4hr charts inclusive.

That might entail the same type of trend line in force on all of those timeframes concurrently (either Supply trend lines for a downtrend or Demand trend lines for an uptrend), but it doesn’t necessarily have to. Pending or recent breaks of counter-trend lines on any of those timeframes are just as instructive, as would be a Fibonacci-based Continuation Pattern setup. So, for example, if we saw intact Supply trend lines on the Monthly and Weekly charts, at the same time as a pending break of a Demand trend line on the Daily, at the same time as a 4hr Downtrend Continuation pattern, then taken together, that multi-timeframe scenario is just as valid with a bearish bias in mind, as would be the case where we simply had Supply trend lines clearly in force on all of them.

The reason why I bring all of this up is that the custom RSI trend/momentum readings mentioned above can definitely help you figure out which bias of trendline you should be looking to draw at any given time.  Instead of relying solely on intuitive judgment about where we should begin to draw trend lines from scratch on any given timeframe, these custom RSI readings can provide us a simple visual cue.  So if the RSI primary trend reading is currently bearish, and has been for some time, then we should expect to draw a Supply trend line. Conversely, if the RSI primary trend reading is bullish, and has been for some time, then we should look to draw a Demand trend line.  And going through that simple process iteratively from the higher timeframes to the lower ones can help you complete a Top-Down Trend Line Analysis.

Here is a simple chart example of the above procedure: When we look at a “clean” Daily chart for EUR/GBP – just price, customized RSI and no other studies or annotations – we can see that despite short-term counter-trend momentum readings (where RSI ticks downwards briefly, but does not cross below the midline), with the indicator remaining generically bullish over the span of at least several bars, the trend is most probably up, and therefore, the line study we should be looking to draw is a bullish Demand trend line. From there, we look for a Swing Point Low or prominent rejection wick low, work backwards to the last one that preceded it, and then join the two lows in successive fashion, just as we normally would (as explained in the Trendline Mastery foundation course).  The second panel in the following two-chart extract shows the “before” and “after” of applying this method:

Exhibit 3: Using RSI Trend Readings to Determine Type of Trendline to Draw

Start by looking at the RSI Primary Trend Reading, which in this example is bullish.
Since RSI is bullish, the appropriate type of trendline to draw would be a Demand trendline.

One other point that should be made in this regard is that when you see an intact RSI Primary Trend Reading together with a counter-trend Momentum reading (RSI ticking up from below 50, or ticking down from above 50), you often can make out the latest “swing” which corresponds with a connection point for drawing a trend line on the price panel at or near that particular juncture.

Going through the process of reading RSI top-down and using that information to guide you in terms of the appropriate bias of trend line drawing to do can really help you with your Top-Down trend assessments. In the mini-case study example we will look at in just a moment, you will see how this works with actual chart examples.

Fourth Step: Lining Up the Readings On Multiple Timeframes For Breakout Trending Moves

Now here’s a dead-simple idea that might seem kind of difficult on the face of it, but if you’re set up for with the proper analytical and trading tools, can actually be profoundly powerful.  And the idea is this: When you have the technical validation to convey confidence in the underlying indicator readings (again, by way of Top-Down Trend Line Analysis on multiple timeframes), it is when RSI is simultaneously generating both a Primary Trend Reading and a compatible Momentum reading (ticking lower below 50 for bearish or ticking higher above 50 for bullish) across multiple timeframes that you have the strongest possible technical reading of a fast moving “breakout” market profile.

Though different traders have differing tastes when it comes to the range and extent of lower intraday timeframes to work with, we can say generally that if RSI is bearish ticking down in real-time on all of the Monthly, Weekly, Daily, 4hr and 60m timeframes concurrently, you should be able to conclude you have a high-probability short bias. And, conversely, when you see RSI is bullish and ticking up in real-time on all of the five above-mentioned timeframes, you should be able to conclude you have a high-probability long bias.

When you look at multiple timeframe side by side, it might appear on passing glance that because RSI is so often “jittery” from one bar to the next (again, particularly on the lower timeframes), that it might seem like a daunting task to line up the same trend-plus-momentum readings on multiple timeframes at any given time. All I can say to counter that concern is to encourage you to keep in mind the time scale involved in each individual RSI reading: On the Daily chart, a certain reading might last all day. On the 4hr chart, ditto for the next four hours, and so on.  When you are actually trading this information in real-time, you can very easily find yourself having plenty enough time to both anticipate the desired multi-timeframe confluence, and act on it.  To do so, a smartly coded Market Screener functionality and/or Chart Alarm tool can be indispensible. Though it is beyond the scope of this article to specify such things in greater detail, I am happy to mention in passing that for any of our audience who happens to be a user of the ProRealTime charting platform, I would be willing to share with you the ProScreener coding I have developed for “PRE” and “POST” screener readings applicable to this concept. To get your free Notepad file of this coding, simply send me an email request via frank@forexmentor.com.

Mini Case Study Example: RSI/Trendline Short Bias on GBP/CAD on Monday, August 15th, 2016

What I’d like to do now is walk you through several chart timeframes top-down, focusing on the GBP/CAD pair during the London session for Monday, August 15th, 2016. Our objective here will be to show you how the RSI trend/momentum readings mentioned above, combined with Trend Line Analysis on each individual timeframe, combined for a powerful multi-timeframe short bias.

We’ll begin with the Monthly chart. From before the close of the February, 2016 monthly bar (highlighted with a dashed vertical line), RSI was crossing down and through the 50 line from above. Despite a short-lived and shallow blip back above the midline during May’s monthly bar, by the time we get to the August, 2016 bar on the far right-hand side, we can see that the RSI reading is consistently bearish. This clues us in to the fact that it is probably be a bearish trendline annotation that’s called for. And in working backwards from August, we can see rejection highs on the Monthly bars for May and January. Drawing a diagonal line downwards from above provides us a valid Supply trend line. And – hey presto – we have a high-level downtrend clearly annotated on this timeframe.

Exhibit 4: Monthly Chart (GBP/CAD Case Study Example)

Next, we’ll drill down to the Weekly chart. From the Weekly bar open for February 15th, 2016 onwards without reversal, we see RSI consistently remaining below the midline value of 50.  And sure enough, every single up close against the downtrend, or even multi-bar upside retracement along the way, eventually resolved downwards for a fresh low below the last one, thus satisfying the definition of a true downtrend.  Notice here too that individual up ticks on RSI against the primary downtrend served to delineate counter-trend moves of varying degree.

Exhibit 5: Weekly Chart (GBP/CAD Case Study Example)

As we drill down next to the Daily chart, the dashed vertical line through the Daily bar for August 4th shows us something really interesting. After RSI briefly crossed above the midline two days prior (a move that could be correctly interpreted as corrective, since the RSI Primary Trend readings on both the Monthly and Weekly charts were still bearish at this point), it crossed back down and through the midline, thus re-establishing the downtrend reading on this timeframe. As this event transpired, we could see on the price panel itself how a prior corrective Demand trendline was being broken in the downwards direction, which in turn marked the end of the upside retracement from the “B” juncture of the large-scaled Fibonacci-style Downtrend Continuation pattern it was possible to draw previously.

Exhibit 6: Daily Chart (GBP/CAD Case Study Example)

Next up, the 4hr chart.  Once RSI crossed back down and through the midline on this timeframe, which occurred on the close for 8/04/4:00am GMT, we had a bearish trend confirmation on this chart, which aligned with like RSI trend readings on all of the higher timeframes.  By the time we get to the daily session for Monday, August 15th, 2016, we can see that a persistently bearish RSI Primary Trend reading provides the guidance for us to low for a progression of lower highs to join together by way of a Supply trend line. In fact, on this timeframe we can see not just one, but in fact three intact Supply lines, the third sharper angled than the second, the second sharper angled than the first (a phenomenon I refer to as “trend line acceleration”, which in turn conveys stronger momentum for a given trend, over time).

Exhibit 7: 4hr Chart (GBP/CAD Case Study Example)

We could take this style of analysis to successively lower timeframes until we end up all the way down on the 1m chart, using RSI crossovers through the midline as potential entry triggers. However, I think we can finish off this example sufficing with the 60m chart as a way of connecting the technical picture on just one intraday timeframe with that provided by our combined RSI/trendline approach on all of the higher timeframes.

This time, the dashed vertical line annotation is used not to show us where a bearish trend reading starts on this timeframe (we would actually have to go back in time further to find it). What it does instead is show us where we have a counter-trend momentum reading on a prior bar resolving into a fully bearish reading where RSI is ticking down below 50, at the exact same time as we get that same basic “pattern” reading manifest on all other timeframes simultaneously.  This multi-timeframe agreement constitutes a “POST” screen RSI reading (where a corrective reading on at least one timeframe resolves to trend and brings all timeframes into agreement) and it can serve as a powerful real-time entry signal in its own right, or even just a confirmation of some other technical trigger you may prefer to work with.  To be precise, on the GBP/CAD 60m open for 8/15/5:00am GMT at an entry price of 1.6749, RSI ticked down again on the preceding 60m close following a short-lived corrective reading, and that in turn occurred with RSI bearish and ticking lower simultaneously on all of the Monthly down to 4hr charts inclusive.  The follow-through which ensued speaks for itself: A strong, reliable “Impulse Wave” coming in the aftermath of a prior upside retracement on the 60m chart. And that is exactly what it means to “sell the corrective rallies” in the downtrend, which is always the trend trader’s objective when there is compelling reason to hold a bearish bias.

Exhibit 8: 60m Chart (GBP/CAD Case Study Example)

For now, we’ve probably shared enough information on this alternative RSI trend reading technique that you’ll want to take some time to digest it, reflect on it, maybe even play with it in demo mode in your own dealing/charting platforms, to see if this concept might work for you. So we’ll call it a wrap for now, but bearing in mind that we’ll likely take the time to show you examples of this concept in action, via upcoming Trendline Mastery Trader’s Club “Trade Recap” and/or “Hot Picks” video presentations and/or via our weekly TM Live webinar sessions.

To summarize, in this article we showed you a second alternative formatting treatment you can use on the RSI indicator (in addition to the “Signal Line” concept we presented previously), involving the insertion of a midline on the indicator panel with a value of 50. We also showed you how this format provides the opportunity to derive two readings at once on any given timeframe: A Primary Trend reading, and a shorter-term Momentum reading.  We also explained how you can use RSI Trend readings to simply derive a bias that tells you what type of trend line you should be looking to draw on any given timeframe. We furthermore explained how a confluence of strong RSI trend readings across multiple timeframes simultaneously tends to align with strong breakout moves, and we underscored that message with reference to a mini “Case Study” example involving the GBP/CAD pair for the London session of Monday, August 15th. 2016.

I hope you have found this latest installment in our Trendline Mastery monthly blog series useful and informative. As always, we welcome your comments, questions and feedback, which you can submit either email frank@forexmentor.com.

Looking forward to seeing you here for our next installment in September. In the meantime: 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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