How to Use A Signal Line with RSI and Top-Down TL Analysis

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Welcome to our monthly blog article for September, 2016, sponsored by the Trend line Mastery Trader’s Club membership service, and related foundation course.

If you happen to have read our posting here for July, 2016 (entitled “A Detailed Anatomy of a Top-Down Trend Trade Setup Using RSI with a Signal Line”), you will see that we reference (in the fourth paragraph from top) two weekly blog posts originally published to a site that was called TrendTradeForex.com.  That free blog site is no longer available, and with its discontinuation, the archived versions of the two articles cited are also no longer available.  However, they are both highly relevant to the topic of using RSI in conjunction with Top-Down Trend line based trading techniques. Furthermore, we have received requests for PDF versions of those articles from several members in recent weeks, which suggests that the topic may be of interest to our members, and other traders.

So, in the interest of making the above commentary available once again, we are using the occasion of this month’s TM Blog installment to combine the two weekly articles in question.  They are entitled “Two Really Handy Things You Can Do To Make The RSI Indicator Come Alive”, and “Using RSI/Signal Crossovers As An Entry Trigger to a Trend Trade” . In the sections that follow, we are repeating the text of those two pieces as “Part 1” and “Part 2” (respectively) of this month’s TM Trader’s Club blog.  We hope will enjoy this two-part article.

PART 1: TWO REALLY HANDY THINGS YOU CAN DO TO MAKE THE RSI INDICATOR COME ALIVE

(Originally published at TrendTradeForex.com on June 28th, 2016)

As you know by now, the only indicator we’ve referenced in any of our content is the Relative Strength Index, or RSI. This is not to suggest or imply that other indicators are less useful; it just happens that RSI is the one indicator that is most directly amenable to trend line analysis, which is the basic technique we use to identify both trending markets and counter-trend setups.

That said, if you’ve ever struggled with making sense of the readings RSI can generate – and let’s say that is more likely to be true if you don’t like drawing trend lines on it – then you might find the topic of this post to be of potential interest.

What I’d like to do here is show you two different things you can do with RSI that make it easier to work with for the purposes of:

  • Getting an easier to detect trend reading from RSI; and:
  • Using RSI to identify potential Continuation Pattern setups.

Let me start with the first of the above two ideas.

Getting Better Trend Readings from RSI Using a Signal Overlay

We all know that RSI in its default configuration can be pretty “jittery”.  Though one might sense that the indicator is moving either generally upwards from left to right on the chart, or alternatively generally downwards from left to right (or alternatively, generally flat), RSI nevertheless tends to sport a lot of little “blip” readings here and there, putting in short-lived notches up and down.  All that jitteriness makes it harder to get a clear reading out of this indicator as compared to when you have  a strong trending market conveyed by those smooth Gap & Angle readings that indicators like the Exponential Moving Average (EMA) and MACD sometimes generate.

If that jitteriness throws you off, I have a potential solution for you which might prove to be helpful.  That solution is to plot as an indicator overlay, on top of the RSI panel, a 20-period Exponential Moving Average. You can think of this overlay as the equivalent of a “signal” line such as is incorporated in the default configuration of MACD, or as the %D line in a conventional Stochastics configuration.  True to definition, the 20EMA signal line on RSI smoothes out a lot the jitteriness inherent in the indicator itself, and at the same time can tell you whether a trend is still intact even if RSI may be making a “blip” against it.

Now, the first order of business to make this change to the indicator configuration is to determine whether the charting platform you are working with allows for indicator plots within the RSI panel itself. Most charting platforms do allow customizations like this, but not all of them do. The charting service I work with myself – the ProRealTime platform (www.prorealtime.com) – does include this capability. I simply go to my indicator settings once I have RSI plotted on my chart when setting up my template for the first time, and use the “Add Indicator” functionality to plot the 20EMA directly onto RSI.  Hopefully the charting package you work with provides this capability as well. If not, then perhaps one of the many free-access “white label” charting services which brokers often provide when opening a demo account could be another option for you to check out this technique.

Once you have the 20EMA signal line plotted on RSI, you will want to consider two very dead-simple interpretive rules which allow you to obtain a quick and easy visual definition of a trending market. Those rules are as follows:

Two Simple Interpretive Rules:

  • If RSI lies above the 20EMA Signal line, and the current value of the latter is higher than on the most recent Close (in other words, if RSI is above an up-sloping Signal line), then RSI is indicating an up-trending market on that timeframe.

Conversely…

  • If RSI lies below the 20EMA Signal line, and the current value of the latter is lower than on the most recent Close (in other words, if RSI is below a down-sloping Signal line), then RSI is indicating a down-trending market on that timeframe.

With respective to the above interpretive rules, It is important to point out that it doesn’t specifically matter for the sake of the trend reading whether RSI itself is ticking up or down in relation to either an up-trending or down-trending RSI – just so long as it remains above an up-sloping Signal, or below a down-sloping Signal, that’s all that matters. Only when RSI crosses through the Signal line to the other side would we then conclude the prior trend reading was possibly or even probably no longer valid.

The following chart extracts convey both bullish (top) and bearish (bottom) RSI trend readings that reflect the above-mentioned interpretive rules.

Chart Extract 1: Sample Bullish RSI-to-Signal Line Reading

Chart Extract 2: Sample Bearish RSI-to-Signal Line Reading

Though it’s a subject of sufficient complexity  to justify a blog entry all on its own (or perhaps an entire trading course!), we should at least mention in passing that the best application of this RSI trend reading concept is in the context of multi-timeframe analysis. Let’s say you have the same uptrend or downtrend reading across two, three or maybe even four consecutive timeframes. When you drill down to a lower timeframe and see a counter-trend RSI reading on that lower timeframe resolve to the same side of the trend conveyed by the higher timeframes, that event can very often serve as an effective entry point in its own right. But we’ll just leave it there for now, since multi-timeframe applications of this concept would take longer to explain that we have time for here.

Detecting Potential Corrective Moves Serving as Entry Signals

One of the reasons why I like RSI so much is that it very often behaves similar to price itself, and as a result, it very often outlines the equivalent of Continuation Pattern setups – sometimes when those setups are not necessarily easy to see on the price panel itself!

It goes like this: If RSI is trending in relation to its Signal line, but on a counter-trend reading confirmed by one close RSI angles inwards towards the Signal, what you every often see is the equivalent of a Continuation Pattern on RSI itself. So if the trend is up (again, RSI above an up-sloping Signal line), and RSI closes down towards the Signal but without breaking it, you can very often discern the outlines of a small “Impulse Wave” followed by a “retracement”.  If we then look to enter the trade in the trending direction as soon as the retracement is confirmed by a single counter-trend close on RSI, we can often achieve a reasonably precise approximation of literally “buying the dips in the uptrend” or “selling the rallies in the downtrend”.

We won’t get into the details of trade management in relation to this technique, but keeping in mind that a relatively tight Initial Protective Stop of just 20 pips if usually good enough to withstand “noise” when executing on a low-level timeframe like the 60m, 15m or 5m charts, you might just be surprised by how easy, objective and mechanical this type of trend-trade entry trigger can be.  At the risk of repetition, though, absolutely critical to using this technique successfully is that you make sure you are placing the entry signal in question in context of a multi-timeframe strong RSI trend reading, not to mention more usual precautions such as not entering long just below strong resistance, or entering short above strong support.

To demonstrate this pseudo-Continuation Pattern entry signal concept, please see the chart extract below. You will notice that I have attached three labels to RSI, which correspond to the usual three-label scheme shown in Fibonacci-based Continuation Pattern setups we apply on the price panel regularly. It is on the first close after the “B” juncture (anticipating a subsequent “C”) where we look to enter the trade in the trending direction. That technique is literally the RSI technique of “buying the dips in the uptrend”.

Chart Extract 3: Continuation Pattern Entry Signal on RSI

PART 2: USING RSI/SIGNAL CROSSOVERS AS AN ENTRY TRIGGER TO A TREND TRADE

(Originally published at TrendTradeForex.com on July 6th, 2016)

For this discussion, I’d like to come back to the indicator topic addressed in last week’s post. As you’ll recall, that discussion addressed the idea of adding a 20-period Exponential Moving Average (EMA) as a “Signal” line overlay to a standard 14-period Relative Strength Index.  The basic idea there was that if you see RSI painting in below a down sloping Signal reading, the trend bias is bearish. Conversely, if you see RSI painting in above an up sloping Signal reading, the trend bias – at least on that timeframe in isolation – is probably bullish.

This Signal line customization helps us make sense of RSI when it is otherwise prone to “jitters” one bar to the next, and thus often a challenge to read.  In this respect, RSI starts to behave more like MACD or Stochastics, both of which plot a faster “leading” line versus a slower “lagging” line. (Although I would contend that this alternate format for RSI invariably performs better than either MACD or Stochastics).

In last week’s post, we also addressed the idea that individual counter-trend readings of RSI in relation to our Signal line overlay can be read as quasi “continuation patterns”. For example: RSI ticks upwards on a one-bar close towards (but not through) a down sloping Signal line. As long as the trend reading remained bearish through this juncture on two to three higher timeframes, one could interpret the corrective reading on the lower timeframe as providing a potentially actionable signal to sell the rally.

A related, but slightly different concept, that I’d like to put forward now is one that likewise provides a potential real-time entry trigger into a trend trade.  The idea goes like this: Let’s say you have a strong top-down trend reading; like a trend line Quad Screen (i.e. same bias of trend line analysis on four consecutive timeframes, such as Monthly down to 4hr inclusive).  And let’s say that the higher level trend is bearish, and, at the same time, the RSI-to-Signal readings are also bearish as we drill down successively through the lower timeframes, including at least the 60m chart, but maybe even the 15m chart.  In this scenario, it would seem likely that the intraday trend is in agreement with the high level trend, and on most if not all major timeframes in use, there is one clear and predominant trend  bias that recommends itself.

And let’s say we’re really in luck, because just as we’re sitting down at out trading workstations, we see that there is a technical trend trade setup either just coming to fruition or yielding a continuation move in progress, pointing to lower lows ahead.

So we know we want to be in a short position, but we’re in want of some kind of fairly mechanical signal to trigger us into the trade. The assumption here is that you ‘d never want to just jump in any old place without due care, because doing so runs you the risk that you might be entering the market just as the next retracement gets underway, and that could easily result in a stop loss, or at the very least, a large drawdown.  We specifically want to time our entries, either selling on a resistance retest if possible, or selling as price resolves to trend following completion of a low-level corrective top. (As an aside, it should be mentioned that in a specifically fast-moving trending market, it can be harder to get those multi-bars long resistance retest events, as compared to more “normal”, slower moving market scenarios, where they are arguably more frequent).

The kind of entry trigger can help us in this regard is when RSI makes a counter-trend reading in relation to its Signal line on one of the two lowest intraday timeframes: typically either the 15m or 5m charts.  So, in the case of a downtrend, we’d be looking for RSI to cross up above its Signal line (on the first close in that direction).  If you use a charting platform that includes a built-in alarm function, you can set the parameters so that you get an audio alert and/or popup alert when this occurs. Let’s say this happens on the 5m chart.  As long as this counter-trend event does not significantly alter the RSI trend readings on the next higher timeframe, then the correction is of 5m degree. This means that it is a micro-retracement likely limited to the 5m chart view, and we can assume that, unless it expands in terms of time and price, perhaps eventually morphing over to the next higher timeframe (i.e. 15m), and the next after that (i.e. 60m) and so on,  then once it resolves back into the trending direction, we may have a viable entry signal.

So how do we know the 5m retracement is “resolving” to the higher level trend?  The most visually obvious way is to get confirmation of RSI crossing back down and through the Signal line on the 5m close. As long as the RSI trend readings on all higher timeframes remain intact at the point that the 5m RSI makes the bearish crossover, and as long as there are no apparent impediments to the trade (whether a pending high-volatility news event or price approaching a strong Support level), then the crossover event in question comprises the real-time entry trigger we’re looking for.

Consider the chart extracts below. Chart extract #1 is the 15m chart, and Chart extract #2 is the 5m chart. For the sake of completeness, we could potentially post several other higher timeframe views as well, but for the sake of efficiency, let’s just make the assumption that the trend readings shown on the 15m chart are representative of those on the higher timeframes; i.e. we have a valid Top-Down bearish trend reading.

Chart Extract 4: 15m Chart View Conveying The Top-Down RSI Trend Reading

Chart Extract 5: 5m Chart View Conveying The RSI Crossover Entry Signal

These two charts are marked with vertical lines labeled “A” and “B”, and those marking show you where we were at the same time on both charts.  The “A” juncture is an instance of a counter-trend reading getting underway on the 5m version of the indicator panel: RSI crosses up and through its Signal line. Notice what this does to the 15m RSI as this occurs, at the same “A” juncture: precisely nothing. In other words, the lower timeframe RSI crossover did not alter the higher timeframe bearish RSI reading. And that’s exactly what we want to see.

Later, when the 5m RSI crosses back and down through its Signal line (at “B”), we can see that even though the 15m RSI had briefly blipped upwards, it did still respects its down sloping Signal line, confirming the higher timeframe downtrend.  So, at the first open after confirmation of the RSI crossover – juncture “B” on that timeframe – we have a valid entry trigger. Though price made a hard corrective bounce later in the session, there was zero chance for a hard stop loss on this trade entry, and floating profit of almost 200 pips was generated before price turned upwards in the next retracement.

So there you have it: The “fractal” concept in action, whereby an interruption against the trend that is small enough as to be isolated to a lower timeframe without disturbing the trend reading on the higher timeframe, provides the basis for a real-time entry trigger when an RSI crossover in the trending direction subsequently materializes. All subject, of course, to some common-sense trade entry filters that would apply regardless of the trading methodology preferred.

In general, then, we can come to the conclusion that the 20-period Signal line overlay on RSI which we first addressed in last week’s blog post provides not only a useful trend reading function in a top-down context, but also a particular type of crossover-style real-time entry trigger.

That takes us to the end of this latest weekly blog post. I hope you found it useful and informative.

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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