Welcome to this fourth monthly blog sponsored by the Trendline Mastery home-study course and membership service, available exclusively from Forexmentor. Last month’s article was entitled “A Simple Indicator Configuration to Confirm a Tradable Trend”. In that article, we talked about some of the common, off-the-shelf indicators that can be used in conjunction with Top-Down Trendline Analysis, if you are not comfortable with the idea of deferring only to “naked” price action. Again, the process of becoming the trader you want to be involves picking and choosing from available options, so to the question whether with or without indicators in your chart template, there is probably no universally “right” answer, and it is up to you to decide which approach works best for you.
In this month’s installment, we’re going to talk about indicators again (one in particular, actually), but with an entirely different purpose in mind. Specifically, we’re going to show you a novel – and highly effective – adaptation of Top-Down Trendline Analysis that involves drawing your trend lines not on the price panel (although that is of course a completely legitimate supplement to what we’ll be focusing on here), but rather directly on an indicator panel itself.
A Brief Introduction
The specific indicator that will come in handy for our purpose is the Relative Strength Index (or RSI). We will be sticking with the usual RSI setting of (14), which is the default variable for virtually any charting package which includes it. So, there will be no tweaks to make in the settings window, but one formatting suggestion we would make is to eliminate the so-called “overbought” and “oversold” horizontal reference lines, which are typically plotted at levels of 70 and 30, respectively.
The reason for that recommendation is that there is no arbitrarily set mathematical threshold derived from any indicator that can ever be counted on always, consistently, and reliably to signal an “overbought” or “oversold” reading. If you need proof to substantiate that argument, simply pull up any number of charts for any pairs that interest you, and look at all the times that RSI went above 70 or below 30 in a strong, top-down trending scenario, and then ask yourself: Did the tradable trend really end there, or did price easily enough go on to make a higher high in the uptrend, or a lower low in the downtrend? The answer is sometimes “yes”, sometimes “no”, but that’s not really good enough. In any event, we would suggest that if adhering to the principle of Top-Down Analysis, you can safely bypass Overbought/Oversold levels on RSI and be none the worse off for it.
We should also mention from the outset that the technique of drawing trendlines on an indicator seems to lend itself well only to RSI, and there are apparently no other commonly found indicators that are amenable to this style of analysis. You can’t draw trendlines on a Moving Average, because the whole point of that indicator is to smooth out the various swings that enable trendline drawing to begin with. The same issue applies to MACD. And even to Stochastics, despite the fact that it tends to be more “noise”-prone than Moving Averages or MACD. One could theoretically try applying the method to the Commodity Channel Index (CCI) indicator, and if that is your personal, all-time favourite indicator, then so be it. Generally, though, what you would find over longer periods of time , if comparing the applicability of RSI to CCI for trendline annotations, is that RSI is superior, as it captures many more of the swings in price, which are often smoothed out by CCI.
What’s The Rationale?
Since the publication of the Trendline Mastery foundation course in August, 2015, and through the course of numerous case study presentations to the Trendline Mastery Trader’s Club from its launch several months later, we have always focused our attention on the price panel when it comes to marking up our charts with annotations designed to capture a prevailing trend direction. And, obviously, that method is time-tested and true and a good starting point.
But as it so happens, doing the same sort of analysis on the RSI panel itself can very often alert us to trend lines that are not as apparent – or possibly apparent at all – if looking for them exclusively on the price panel.
Why would this be the case?
Well, for one thing, the conventional approach to trendline analysis drawn on the price panel involves connecting two or more Swing Points or individual Rejection Wicks – specifically on the lows (for a Rising Support or Demand trendline), or on the highs (for a Falling Resistance or Supply trendline). Exhibit 1 below provide a visual reminder of what both types of price-based trendline look like:
Now, when we focus on lows or highs as connection points for trend lines, we miss another potentially important piece of information; specifically, closes (which, aside from weekend gap opens, are usually synonymous with adjacent opens in the continuous 24-hour Forex market). And if you are simply not looking at closes, then you are of course probably not going to find cause to draw trend lines on them. But this style of trendline drawing is 100% valid and useful – in fact, very often to a greater extent that conventional price panel based drawing approaches, including the much-referenced Tom DeMark method.
Before we take a moment to try and prove the preceding point, let’s consider an interesting facet of RSI. If you ever happen to have been curious as to how RSI compares to a simple line-plot format of price (instead of the usual candlestick or bar formats), you would have noticed that these two metrics of price action are very often almost identical in appearance – but not always. Take a look at Exhibit 2 below, for instance. The top panel replaces the usual candlestick plot of price action with a simple line plot based on the Close, while the panel below it shows a standard RSI(14). Both seem to rise and fall at the same junctures, and often by the same magnitude.
Pretty uncanny resemblance, isn’t it? But in case you’re wondering whether RSI is 100% redundant with a line plot of price action on the Close, the answer is “no”, it actually isn’t. We won’t delve too deeply into the reasons why that is the case, as it pertains to the underlying mathematics of the indicator, a subject which might take us too far off on a tangent that doesn’t really matter. Suffice to say, that RSI is an index – all values it plots must by necessity fit to within a scale from a lowest possible value of zero, to a highest possible value of 100, regardless whatever price is doing. In other words, RSI is a so-called “bounded” indicator. But because price itself is not “bounded” the same way that RSI is, the two metrics of market advance/decline do not have to specifically behave the same way at the same time all the time. In other words, RSI could make an absolute peak at 100, occurring in tandem with a fresh high on price, but price is not specifically obligated to “retrace” from that high, whereas RSI must.
If all of that sounds confusing, we can make things easier for ourselves by simply accepting the premise that, while RSI and a line plot of the price panel Close often seem to map out the same relative lines, dips or spikes at the same times, they do not necessarily always show the exact same information at the same time.
Speaking from a strictly personal perspective, the #1 reason why I absolutely love drawing trend lines on RSI is because – as I mentioned just a moment ago – they very often show me things that are harder to see on the price panel. And that includes not just diagonal Support and Resistance lines, but also horizontal lines that are analogous to key levels (typically Old Highs and Lows) which we likewise capture on the price panel with horizontal Support or Resistance lines. Again, the reason why this is so comes down to a combination of two main factors:
- RSI more directly reflects the Closes on the price panel, rather than the highs or lows we use to draw trendlines there; and
- The underlying mathematics of RSI generate “swings” which are sometimes different from those found on the price panel.
All of this conspires to make possible a different way of visualizing and interpreting both directional bias, and turning points in price action.
Let’s look at Exhibit 3 (below) as but one of thousands upon thousands of illustrations we could easily derive, whereby a trendline drawn on RSI is not concurrently apparent on the price panel:
In the above example, we see a clear and obvious progression of higher Swing Lows on the RSI panel which align as multiple consecutive connection points for a Rising Support Trendline. The corresponding action on the price panel immediately above, however, looked like nothing more than fairly typical “consolidation”, with price floating aimlessly within two horizontal boundaries of support and resistance. On the price panel alone, it would have been hard to find connection points to draw a proper Tom DeMark style Demand trendline. If that trend sequence was a useful thing to find within Top-Down Analysis for the purpose of confirming a bullish bias overall, this one ambiguous looking timeframe might have been enough to keep us on the sidelines; perhaps for all the wrong reasons.
Now, you might be tempted to retort that a scenario where price goes one way and an indicator goes the other way amounts to nothing more than “divergence”, a phenomenon you can pick up on by way of a variety of indicators including not only RSI, but also MACD, Stochastics, CCI, and others. And, indeed, RSI is extremely useful for plotting divergences. But that is actually not the phenomenon we specifically have in mind here. Rather, it is when price is not specifically trending in either direction based on a clear progression of lower lows or higher highs and yet RSI makes a trendline, that the indicator-based adaptation of our core method becomes really handy. After all, how many of us have, truly speaking, never once seen a trend only after it has passed us by, because when the optimal entry point materialized (in hindsight), it seemed to do so in the midst of price action that was confusing or ambiguous? If we can remove that ambiguity, and gain a more timely insight into a trend cycle as it unfolds, then we should be able to improve our hit rate, over time.
So, let’s just say that RSI trendlines are valuable, and the reason why they are is because they often materialize in relation to swings that do not necessarily lend themselves well (or possibly at all) to conventional price-panel based trendline studies.
So How Do We Do It Then?
In a general sense, we want to apply our trendline annotations on the RSI panel in the same iterative way we would pursue a more conventional price-panel based approach: Top-Down. And to do that, we begin with the highest timeframes and work our way down to the lowest timeframes. If you are using a conventional six-chart multi-timeframe format (comprised of the Monthly, Weekly, Daily, 4hr, 60m, and 15m – leaving the 5m chart in the category of “strictly optional” depending on your tastes), then you would begin your analysis with the Monthly chart. Then on to the Weekly, then on to the Daily, and so on. And the one thing you are most interested in finding through this process, is instances of where the RSI trendline intact on one timeframe conveys the same bias as that found on the next lower timeframe. In fact, the more timeframes that are “pulling together” in terms of compatible RSI trend lines at the same time, the stronger the trend is likely to be in most cases.
If you are familiar with the “Forecast Pack” PDF reports we publish Tuesdays and Thursdays each week for the Trendline Mastery Trader’s Club, you will know that we prioritize trending pairs on the basis of a singular definition, which is that the same trendline bias (bullish on all or bearish on all) is conveyed on all four of the Monthly, Weekly, Daily and 4hr charts. That is not the only conceivable scenario in which a trend may be actionable, but it is a good one (if for no other reasons than it is simple, repetitive, and directly reflects the principle of Top-Down), and worth paying attention to.
The happy news here, is that this very same multi-timeframe definition of a trending market can also be used when applying the RSI-based trendline drawing method: If you have intact RSI Demand trendlines apparent on all of the Monthly, Weekly, Daily and 4hr charts, you have a strong uptrend. If you have intact RSI Supply trendlines apparent on all of those timeframes, you have a strong downtrend. And if you have little agreement amongst those timeframes, it is likely that at least one is in the midst of a major corrective move, and only when it breaks out (thereby confirming a top-down reading) would you be able to prioritize it as potentially trend-tradable.
But, aside from the issue of how to integrate multiple timeframes in the analysis, we still haven’t addressed the practicality of how to draw trendlines on RSI. So let’s do that now…
When you pull up any single chart, you will want to work backwards from the live edge of price action on the right side of the chart, further back in time. You will want to pay close attention to all the various little blips and spikes which, to the untrained eye unfamiliar with the techniques we’re talking about here, may amount to a whole lot of confusing “noise” providing every reason in the world not to work with this indicator (little do most such people realize that it is precisely all this “noise” which makes RSI so helpful and useful to us!).
As you look through all these blips and spikes, you will want to pay particular attention to the more prominent ones, while putting less emphasis on the really small ones. And you will want to naturally gravitate to instances where you can connect spikes upwards aligning in a falling progression (i.e. lower highs) or spikes downwards aligning in a rising progression (i.e. higher lows), and then connect those quasi “swings” with Supply or Resistance trendlines. And in that respect, it’s pretty much the same procedure as when connecting Swing Points and/or Rejection Wicks on the price panel. Again, though, keep in mind that the swings on RSI are not reflective of swings on the highs or lows, but rather on the closes. And that is why you sometimes will, and sometimes will not, see trendlines of like fashion on the price panel at the same time.
Let’s look at Exhibit 4 below to see how this works. In the first panel, we see a blank RSI panel. In the second panel, we see spikes on RSI, which seem to represent swings on the closing value of price (indexed to the RSI scale extending from zero to 100). In the third panel, we draw a trendline which connects those spikes, and as long as RSI remained on the same side of that trendline, it was conveying a directional bias on price, which might not have been immediately apparent in other ways.
We could probably devote an entire article or even course on how to draw trendlines, but that would really bog down our conversation. The best thing for you to do to get the concept under your skin, is to simply start practising it – just go ahead and draw as many trendlines connecting the “spikes” (or “swings”) on RSI as you can, for any given timeframe. If you’re practised in conventional trendline drawing techniques as explained in the Trendline Mastery foundation course, then this technique may come to you quickly, intuitively and easily. If it does not, there’s no need to despair – all that you need to do in that case is simple…keep practising! As you do, take the time to consider what happens on the price panel over the span of time captured by your trendline drawings: Which RSI trendlines that you drew were valid, which ones weren’t – and why? There’s only so much a mentor or instructor can explain by way of formal principles and textbook examples; at a certain point, you need to attain mastery of the concept by studying and researching it yourself, noticing things about it that represent its “behavior” in relation to price action.
What Functions Do RSI Trend Lines Fulfill ?
Now, aside from putting something on our charts that simply “looks really cool”, our analytical studies should fulfill critically important roles that help us find trading opportunities. In the case of RSI, there are four functions I can think of that would be potentially useful at any given time for those who describe themselves as “trend traders”. They are as follows:
- Trend Bias: The first and most obvious use of an RSI trend line is to convey a directional bias – but again, only if that aligns on several timeframes, not just one. If we can draw a Rising Support (aka “Demand”) trend line under a progression of two or more higher down spikes or swings on RSI, then we should have evidence that price is an uptrend – as long as RSI remains above that trend line. If we can draw a Falling Resistance (aka “Supply”) trend line atop a progression of two or more lower up spikes or swings on RSI, then we should have evidence that price is an downtrend – as long as RSI remains above that trend line.
We can further break down this function into two types:
- Visible trend bias: When a trendline on RSI aligns with a concurrent trendline that can be drawn directly on the price panel itself.
- Hidden trend bias: When a trendline on RSI manifests itself as no concurrent trendline is visibly apparent at the same time on the price panel.
- Trend Reversal: When RSI breaks through its own trendline, there are two possibilities as to what might be unfolding. One is that price is undertaking a retracement against the higher level-trend. That scenario is easier to determine with recourse to Top-Down Analysis: Where an RSI trendline is broken in the opposite direction on a lower timeframe, but the trendline on the next higher timeframe remains intact, then the break on the lower is more likely to be indicative of a retracement. Another possibility is that the trend in question is in the early stages of an outright reversal in the opposite direction: from down to up, or from up to down. Unfortunately, it’s just a fact of life in trading that a small reversal that starts off looking like “only” a retracement can only be confirmed as something else with the passage of time and an extension of the move that eventually manifests itself on one or more higher timeframes (if only it was possible to have just a single timeframe in trading – our lives would be so much easier!).
- Divergence: When you’re bullish on a pair, but price makes a higher high as RSI makes a resistance trendline into a progression of two or more descending swings, you have a scenario where it might not be prudent to pursue the trend trade in the preceding direction, at least for the time being. Depending on which timeframe the divergence was detected on (its significance is generally greater the higher up it materializes), it is generally best to look for a reversal event of some kind – either on RSI or on price (or on both) – which occurs after the onset of divergence, before looking to get back into the trend trade, assuming the top-down metrics still align in that fashion. Alternatively, a divergence reading that seems to be occurring in conjunction with a true top or bottom may be the very thing to get you in early on a trend trade in the new direction, to the extent that you can anticipate it.
- Entry Trigger: In some respects, this is my most favourite function of RSI trend lines –an entry trigger as RSI breaks its own trendline in the direction of the higher level trend. The idea is simple: With a so-called “Quad Screen” RSI trendline reading intact (either all Demand lines or Supply lines, or some combination also involving pending or recent breaks of higher-level corrective trend lines on one or more of those timeframes, concurrently on all of the Monthly, Weekly, Daily and 4hr charts), you then drill down to a lower timeframe, which typically means either the 60m chart or the 15m chart. (And if your personal tastes favour it, maybe even the 5m chart). There, you look for any instance where a corrective trendline can be drawn; simply one that is angled in the opposite direction from the bias conveyed by the Quad Screen on the higher timeframes. Once RSI closes on the other side of the low-level corrective trendline – into the direction of the higher-level timeframes – you have a potential trade entry trigger:
Let’s look at a few more chart examples which illustrate the four functions served by RSI trend lines as mentioned above…
In Exhibit 5 below, we see a Falling Resistance Trendline on the 60m chart for GBP/JPY. We won’t show all four of the upper timeframes that corresponded at the same point in time, but let’s pretend that this chart reading did align in one of these so-called “Quad Screen” scenarios we keep talking about. If you compare the price panel to the RSI panel, you can see very clearly that as long as RSI remained below the resistance line, price did remain within a viable downtrend.
We can actually demonstrate the second of the four RSI trendline functions – Trend Reversal – with recourse to the same chart shown in Exhibit 5. All we need to do in this case is find the circled portion of the trendline where RSI breaks to the other side: Not too long after, price reversed from down to up. That RSI trendline break did an effective job warning us that the prior trend was possibly coming to an end and price was about to head in the opposite direction.
In Exhibit 6 below, we see an effective illustration of the concept of Negative Divergence, which is where price makes a higher high against a lower (or alternatively, flat) high on RSI. Again, the key to determining whether these signals are indicative of a potential trade entry lies in making an assessment as to whether the Divergence in question is likely to indicate only a lower-level retracement (which might be the case for a Negative Divergence on the 15m chart against a massive uptrend reading still intact on the 4hr and higher timeframes), as opposed to a true top or bottom. The reason why we mention the concept of Divergence here at all (not specifically an application of trendline analysis), is that it is clearly predicated on trendline drawings, or at least smaller line segments.
The fourth of the main functions of RSI trendline analysis that we listed in the preceding paragraphs – Entry Trigger – is demonstrated in Exhibit 7 below. In fact, we could almost say that it is a direct consequence of the second of the main functions – Trend Reversal – but the so-called “trends” we might capture with corrective line annotations on the lowest timeframes might be of such small and short-lived scale that applying the word “trend” in such cases might be overkill.
In any event, what we’re looking for here is an instance of a counter-trend Support or Resistance trend line on the RSI panel, but specifically on a lower timeframe only (60m or lower), and specifically in contradiction to a strong and still intact Top-Down trend reading incorporating the upper timeframes. When RSI breaks that corrective line into the trending direction, you have a potentially actionable entry trigger. A critical consideration in this regard is that you wait for the candle close that confirms the trendline break. If you act only on real-time trendline breaks without confirmation on the close, you will almost certainly incur more stop triggers than you need to, since false trendline breaks are a constant hazard, and can only be mitigated by waiting for a close.
In this latest instalment in our monthly Blog series for the Trendline Mastery Trader’s Club, we have attempted to convey the simple and effective technique of applying trendline drawing techniques on the RSI indicator panel, as a useful and effective adjunct to the more conventional techniques typically based on the price panel. As we’ve noted here, RSI Top-Down Trendline Analysis can often show us things that may not be as apparent on the price panel, for four main purposes: 1) Confirming trend bias across multiple timeframes; 2) Confirming trend reversals; 3) Providing divergence readings, and 4) Generating trend-trade entry signals on lower timeframes. All of these applications can be helpful in identifying trend-trade opportunities.
In next month’s article, we’ll return to the topic of RSI Top-Down Analysis, by way of a detailed case study example of a particular trade setup on a particular pair, showing how RSI fulfilled all of the functions mentioned above, for a winning outcome. Definitely worth coming back for, in order to deepen your understanding of this useful concept.
In conclusion, I’d like to thank you for joining us here today. I sincerely hope that this blog article has provided you some useful insights into the topic of trendline analysis for Forex trading. If I can ever answer any questions you might have, please see the Member’s Forum available at the Trendline Mastery membership site (www.forexmentor.com/trendline), or send us an email message (with the subject header “Question on TL Analysis”) to: firstname.lastname@example.org. Please also be sure to follow our Twitter feed (@fxmtrendline).
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.)
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