Best Trading Strategy: How to trade ranges with the RSI indicator?

BY Chris Andreou

|11 25, 2021

The name of the RSI indicator, the Relative Strength Index doesn’t really describe the indicator well. RSI doesn’t measure the relative strength of the market but rather indicates the position of the price in the recent range. When the price is near to its recent range high RSI values tend to be in the so-called overbought area. Likewise, if the price is near to the recent range lows relative to the RSI lookback period the market is said to be in an oversold area. This has different meanings in different types of markets and if you bear with me I will explain what this means.

Let me remind you first of some trading fundamentals that are always relevant regardless of what indicator or indicator settings you are using. The most important analysis you have to make relates to momentum. If you don’t know which direction the prevailing momentum is pointing to you really have no idea where the market is likely to go.

In other words, before you even think about what the RSI indicates, try to establish what kind of market you are dealing with. If it’s a ranging market you will need a very different set of rules than when trading in an uptrend. And, you will obviously need again different rules for trading in a down-trending market.

Remember also, that most of the indicators used by retail traders are just very simple mathematical equations and RSI is no exception. Therefore, the line that indicator plots is a drastic simplification of a rather complex and complicated structure or a process called a market! Therefore, indicators cannot even begin to explain the market fully. There’s a reason after all why indicators are called indicators.

It’s good to bear the above points in mind when using any indicator. They don’t move the markets. It’s the markets that move them. Therefore, what the price does gives the interpretation for the indicator, not the other way around.

So with this in mind let’s take a look at the RSI indicator and how it can help you to trade a range-bound market.

Range bound market

In the above image, we have Gold in a 1h timeframe. Green boxes highlight the time periods when the indicator is either in the oversold or the overbought area. These are often also times when the market is trading near to recent range lows or highs.

I have made the RSI a little more sensitive by reducing the lookback period from the standard 14 periods to 7. With this setting, the indicator moves further away from the 50 level (the blue dotted line) on each price swing. It’s, therefore, more likely that the indicator ventures every now and then into oversold and overbought levels. Notice, however, that there are times when volatility is low and the indicator doesn’t trigger any buy or sell strategies that require the RSI plot to move to these extremes.

To trade successfully with the RSI indicator in a rangebound market you need to follow a routine. Here’s a routine that helps you to decide what kind of trading routine works for you. This example routine is for long trades. For short trades, everything works the same only reversed.

Identify the support and resistance areas that create the boundaries that keep the market in a range-bound mode.
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 long when RSI enters the oversold area
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 overbought zone.

It is important to 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!

Trade Safe,

Janne Muta
Chief Market Analyst
TIOmarkets

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