The Best Trading Strategy: How to trade in downtrends with the RSI indicator?
BY Chris Andreou|November 25, 2021
This is part III of this articles series on how to use the RSI indicator. In the first two articles, I showed you how to use the indicator in ranges and uptrends. In this article we’ll take a look at the use of the RSI indicator in downtrends.
If you haven’t read the first two articles, use these links to get up to speed with what we talked about in them.
For those that rather read this article, I will quickly cover the basics again. These basics are actually of fundamental importance when using any indicator in trading. Regardless of the indicator or indicator parameters what actually is important is your view on the price momentum (or trend). The view on momentum defines how the indications from RSI and other indicators are interpreted. For instance, going short in an uptrend just because RSI is overbought is a sure fire way of losing money.
Therefore, before you consider using the RSI, make sure you understand what the market is doing. If the market is ranging or trending is the primary question you have to answer. Only after you know what kind of market you are dealing with you know how to best use the RSI (and all the other) indicators.
Okay, let’s now take a look at how to trade with the RSI indicator in a downtrend.
In the above AUDUSD (1h) chart the market breaks a support and starts to create lower lows (LL) and lower highs (LH). As per classical technical analysis and the Dow Theory the market is now in a downtrend. This means that it’s more likely to have substantial down moves and only relatively small upmoves.
The key word here is ‘likely’ as, like always in trading, we are dealing with probabilities and not with certainties.
In the above chart, I have highlighted the bars during wich the AUDUSD pair is, as per the RSI indicator, in the overbought territory. This is the timeperiod when the RSI indicates a selling opportunity.
As I explained in the previous articles in this series, I like to set the RSI indicator to a shorter lookback period of 7 so that it’s more sensitive than it would be with the standard 14 periods RSI. I think this setting makes more sense to traders looking for short-term opportunities or trading intraday. You should experiment with different settings and choose the one that makes the most sense to You!
When a market is in a downtrend we look for shorting opportunities. Therefore, we are only interested in selling the rallies and therefore look for the indicator to move above the overbought threshold. Note that instead of focusing on both oversold and overbought conditions (like we would in a ranging market) we ignore the oversold indications when the market is trending down. The simple reason for this is that a market can stay oversold for extended periods of time when it’s trending down.
The above chart is GBPJPY in 1h resolution. It shows how there are times when the market move enough to take the indicator into the overbought area, not even with the shorter lookback period of 7. You make the lookback period even shorter (e.g. 3 periods) but then you’d get more false signals. Also, even with the setting of 7 there are times when the indicator moves above 70 (the threshold for the overbought condition) but the market keeps on rallying higher. This is when you will need your protective stops to limit the risk in the trade. Note, however, that even if you get stopped out you have to be ready to consider another trade in the same direction. This is what happened on November 3rd and 4th 2021 in GBPJPY (the right-hand side of the chart). The first short entry might have been stopped out but the second short trade (when the RSI was overbought) would have paid for the loss and brought some profit on top of it.
Let me again remind you: Never trust the market (or yourself) enough to trade a) without protective stops or with such a large size that you really can’t afford the potential loss. More experienced traders know this, but newcomers might still have these strange misconceptions that they will be so exceptionally good that they don’t need to manage the risk. I can assure you with 20+ years of experience in the markets that these ‘natural talents’ will be soon weeded out by the market.
TIOmarkets has made it possible that I am holding a free strategy workshop webinar every month in which I will teach you genuinely useful trading ideas and strategies. As covering all the aspects of trading with the RSI indicator is beyond the scope of this article I advise you to go to www.TIOmarkets.com/webinars and reserve your seat for the next free webinar. That’s where we can talk about the trade selection process, risk management, targets and any other trading topic you might be interested in.
To trade successfully with the RSI indicator in a down-trending market you need to follow a routine. Here’s an example that helps you to decide what kind of trading routine works for you. This example routine is for short trades.
- Identify a down-trending market using eg. moving averages or the principles highlighted in this article
- Define your maximum risk per trade.
- Decide how far from your entry price you will place your protective stop orders
- Once you have defined your maximum risk and stop distance from the entry you know the maximum position size. Write this down to stay disciplined.
- Prepare to trade short when RSI enters the overbought level. You might want to consider using some other triggers (like a close below a moving average) in addition to the RSI being overbought.
- Enter the trade using the position size written down in your plan.
- Set the stop at the distance determined earlier.
- Exit the trade when the RSI indicator enters the oversold zone or when the market hits your target.
Please remember that: Each indicator and strategy has its strengths and weaknesses and that losing trades are just part and parcel of the package called trading. You will have losing trades, there is no question about it. Therefore, you need to have a good understanding of how often you are likely to get stopped out and what is the relative size of your losing trades compared to your winning trades.
Therefore, it is highly important to test this strategy idea with historical data and then again with live markets using a demo account before considering trading real money with the strategy. This will help you gain confidence and avoid anxiety derived mistakes during drawdown periods.
Hope this helps!
Chief Market Analyst
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