RSI Trendline Strategy – an Effective Reversal Strategy

The RSI Trendline Strategy is essentially a reversal strategy and it makes use of the RSI indicator in an unconventional way.  The Relative Strength Index (RSI) indicator was developed by J. Welles Wilder and it’s a momentum oscillator that measures the speed and change of price movement. The RSI oscillates between 0 and 100 and it’s often used to measure overbought and oversold conditions in the market, divergence or it can be used to identify the general trend. Basically, the RSI is analyzing the total number of down periods versus the total number of up periods and plots the average on the RSI curve. There are many different techniques for using it, but it can be altered depending on each trader’s needs.

RSI Trendline Strategy Setting

According to Wilder the default RSI settings should be 14 periods, but in our proposed strategy we’re going to use the 20 periods as our RSI settings. The reason why we’re going to use the 20 periods is because 20 is multiple of 200 periods, and the 200 periods carries a big influence and it’s a big psychological number often used by the smart money to define an uptrend or a downtrend. We don’t want to use a bigger period because it can signal the beginning of a new trend too late, but we neither want to use a faster period because it can generate a lot of false signals.

We use the RSI indicator to show us if the prevailing trend has ended and a new trend is underway, but as stated above, we’re not going to measure the overbought/oversold conditions or as a crossover system, we’re going to take it one step further and look for a break in momentum of the prevailing trend. What I mean by this is that we’re going to look at the changes in prices relative to the changes in the peak and the valley that the RSI indicator will generate.

As the above chart suggests the RSI-Trendline strategy works best on the 1 hour time frame but with its applicability can be used on any time frame. The rules of the system are straightforward, we only need to connect the most recent RSI peaks or valleys with a trendline and a breakout of the TL will warn us that the market has lost its steam and the prevailing trend has lost its momentum.

There is one more condition that needs to be satisfied in order to enter a trade, we need for the price to still be trading below its trendline, so we’ll need the RSI trendline to be broken, but the price to still be trading below its trendline. This is the most important principle in order for the RSI-Trendline strategy to work because it tells us there is also a divergence between momentum and price. Momentum always goes ahead of price and that’s the reason why this strategy can yield a great return.

RSI Trendline Strategy – Sell Setup

In the above chart, we can have a representation of how a short setup would look like. In terms of stop loss level, we’re always going to use the candle on which the RSI broke its trendline, so in the case of our short setup our SL would be above that candle. In terms of profit target, we’re going to use the RSI again and wait until it’s changing momentum in the opposite direction.