RSI with a Twist
The Relative Strength index, RSI, was developed by Welles Wilder in the late 1970s. His book, New concepts in Technical trading Systems, is a classic that goes into more detail on his indicator. The goal of his RSI indicator is to identify trends, overbought and oversold in any commodity, stock, or tradeable security.
Below is a typical chart of the RSI using the default value of 14 periods.
TQQQ, a leveraged ETF, is used in this example with the RSI(14) plotted across the top. I also plotted an 8 period exponential moving average. (EMA) The RSI is considered overbought at or above 70 and oversold at or below 30. The RSI is also thought of as useful for identifying divergences between the underlying, TQQQ here, and the RSI indicator. Should the underlying hit a new high and the RSI(14) does not, this is viewed as a divergence.
Another way to look at this is to observe the trend of the RSI(14) Trending higher is looked at in most cases as favorable. Some traders see this indicator as positive/bullish for trading above 50 – trending higher and bearish below 50 or trending lower.
Ok, that is the traditional view of the RSI indicator. Here is the twisted underwearmillionaire interpretation. Set the RSI to two periods RSI(2). Below is the same chart of TQQQ and timeframe.
With the RSI(2), a bullish signal is indicated by a cross above the 70 line or value and a bearish signal is given when the RSI(2) crosses below 30. The thought being a cross above 70 is a change in the momentum to the upside and a cross below 30 being a change in the momentum to the downside.
As you can see there are many signals. So using the RSI(2) alone may not yield the greatest trading results. However, I can guarantee you, not every signal leads to a market run, every market run will start with this signal. Think of the RSI(2) as a change in the momentum direction for the near term.
This is not my original idea. This is actually a different take on Larry Connors RSI(2) strategy. In his strategy, he is looking for extremely oversold situations with the RSI(2) reaching levels below 5. While this is a great strategy, it does not work well with my swing-trading style. I need confirmation that the price is moving higher and RSI(2) crossing above 70 is my confirmation.
Looking at the same chart use these Rules for entry/exit
Entry
RSI(2) crosses above 70
AND
The close of the bar is above the 8 period EMA
AND
The previous bar’s close was below the 8 period EMA
All three must be met for an entry
Exit
RSI(2) crosses below 70
AND
The close of the bar closes below the 8 period EMA
AND the previous bar’s close was above the 8 period EMA
Marked with arrows, you can see how the RSI(2) and 8 EMA lead to some good trends. The first trend was +23% entry to exit. The second trade assuming you shorted the market was close to 30% entry (down arrow) to exit (up arrow).
As you can see it works well to confirm other indicators or price action you may be using. It also works any time frame. Below is a 4-hour chart of TQQQ.
The arrows indicate our RSI(2) and 8 EMA strategy but on a 4-hour timeframe.
Below is a weekly chart of TQQQ with the same strategy RSI(2) 8 EMA.
This may not be the holy grail of trading systems and indicators but it has some merit worth examining more closely. I use the RSI(2) and 8 EMA in my toolkit frequently along with other indicators which I will post about later. Try it out on your charts and see what you think. Always practice good money management and run stops!
Happy Trading!
