The relative strength indicator (RSI) is one of the oldest and most popular tools in technical analysis. In fact, if there was a hall of fame for technical analysis indicators, RSI would certainly be accorded top-five status. Its ability to measure turns in price by measuring turns in momentum is unmatched by almost any other tool in technical analysis.
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The standard RSI settings of 70 and 30 serve as clear warnings of overbought and oversold territory. The "RSI rollercoaster" is a setup that can take advantage of these turns in the market. Read on as we cover this strategy and show you how it works in real-life trading examples. (For background reading, see Momentum And The Relative Strength Index and An Introduction To The Relative Strength Indicator.)
The purpose of the RSI rollercoaster is to harvest points from range-bound currency pairs. First and foremost, this setup works best in a range environment when overbought and oversold readings are far more likely to be true signals of a change in direction. The setup is also much more accurate on the daily charts than on smaller time frames like hourly charts. The primary reason for this difference is that daily charts incorporate far more data points into their subsets and, therefore, turns in momentum tend to be more meaningful on longer time frames.
Nevertheless, the asymmetrical structure between risk and reward in this setup makes even the shorter time frames worth considering. Just keep in mind that although the setup will fail far more frequently on the shorter term hourly charts than on the daily ones, the losses will generally be far smaller, keeping the overall risk manageable.
Rules for a Long Trade
Rules for a Short Trade
The key to this RSI strategy - versus the traditional interpretation of RSI, which simply trades overbought or oversold levels - is to first look for a reversal candle, which provides us with a sign of exhaustion before taking the trade. This way, we are prevented from prematurely picking a top or bottom and instead we wait for indicator confirmation. Note that the RSI rollercoaster is designed to squeeze as much profit as possible out of the turn trade. Instead of immediately closing out a position when it moves from oversold to overbought, the RSI rollercoaster keeps the trader in the market until price shows a sign of exhaustion. Sometimes a strong move will generate multiple consecutive periods of overbought RSI readings, and this setup is specifically intended to catch part of these potentially profitable moves.
Note also that the RSI rollercoaster is almost always in the market, as the rule for the liquidation of a long trigger is the creation of a fresh short position. The only two times this setup stays out of the market is when the trader is stopped out of his position on a false signal or when he is stopped out at breakeven on the second half of his position. Now let's take a look at some examples. (For more on the RSI and market strength, check out our Market Strength Tutorial.)
|Figure 1: RSI Rollercoaster, AUD/JPY|
|Source: FXtrek Intellicharts|
In our first example (Figure 1), we look at the AUD/JPY currency pair from approximately December 12, 2005, to April 1, 2006. On December 12, the pair records an RSI reading of 73.84, but at the close of the very next candle the RSI drops to 48.13 and we go short at 88.57. Our stop is set at the most immediate swing high of 91.33, or 276 points back. Our first target is set at 50% of our risk, or 138 points forward. The very next day the pair collapses further and our first profit target is realized. We then move our stop to breakeven and stay in the position until RSI reaches oversold territory. On December 27, 2006, RSI moves up from severely oversold readings below 30 to 30.70.
We exit the second half of the trade at 85.01, harvesting 356 points. Immediately, we initiate a long position at the same price as the RSI rollercoaster has now indicated a buy setup. Our stop is set at the nearest swing low of 84.51. Our risk is a relatively small 50 points and, therefore, our first profit target is a very modest 25 points, which we achieve in the very next candle when prices rise to 85.26. We move our stop to breakeven and stay in the trade for more than a month until February 6, 2006, when RSI leaves the overbought territory and we liquidate the rest of our position at 88.23 for a 322-point profit.
Again, we immediately sell at the same price to establish a new short, as per the setup. The swing high of 89.34 serves as our stop. The first target of 87.68 is achieved the very next day as we bank 55 points. We exit the rest of the position at 84.01 when RSI once again returns from its oversold level. The second half of the position produces a 422-point gain. All in all, the RSI rollercoaster generates a very respectable 660 points (1319/2) over a four-month time frame.
Some traders may not have enough patience to trade the RSI rollercoaster on daily charts, so the next example of the setup is on four-hour charts.
|Figure 2: RSI Rollercoaster, EUR/USD|
|Source: FXtrek Intellicharts|
In the four-hour chart of the EUR/USD (Figure 2), we see the RSI rollercoaster perform well once again. We start on March 21, 2006, as RSI, after spending some time in the overbought zone above 70, finally falls below that value, triggering a short order at market at 1.2178. The swing-high stop is extremely close at 1.2208, allowing us to risk only 30 points on the trade. Our first target at 1.2163 is hit within the next candle and we move the stop to breakeven and follow the trade. The pair eventually trades down to 1.2035 before regaining upside momentum, and we are able to close out the second half of the position with an additional 138-point profit. We then immediately go long at the same price. This time our risk is considerably larger at 100 points, as the swing low lies at 1.1935. Nevertheless, the pair climbs steadily and we reach our first target with ease, exiting at 1.2085 for a 50-point gain. We then stay in the trade until the rules of the setup force us to liquidate at breakeven. All in all, in this example of the RSI rollercoaster we are able to harvest a total of 203 points while risking only 260 points. Although in this sequence the risk reward ratio is a bit less than 1:1, the high probability aspect of this setup generally assures positive expectancy overall. (For more on charts, check out our Analyzing Chart Patterns Tutorial.)
The RSI on a Short Time Frame
Turning now to the one-hour time frame, we see that the RSI rollercoaster performs far worse on the shorter time frame. Starting on April 3, 2006, the setup triggers a short at 1.3090 with a 35-point stop at the swing high of 1.3125. The trade moves our way almost instantly, and we are able to quickly cover half the position for 17-point profit. Again we move our stop to breakeven and stay in the trade all the way to 1.2902, harvesting 197 points in the process. However, before we celebrate too quickly, the setup triggers an immediate long trade and generates three consecutive stop-outs as the RSI peaks above the 30 level only to retreat into oversold territory once again. Overall, we lose -28, -36 and -47 points times two lots.
The cumulative loss? Minus 222 points. The three losses fully negate our one big win, and we actually stand at the end of the run down eight points. To add insult to injury, when the pair does make a turn to the upside, we miss the entry because the rally starts from RSI values above 30 and our setup does not trigger a signal.
|Figure 3: RSI Rollercoaster, USD/CHF|
|Source: FXtrek Intellicharts|
One solution to this problem is to simply not trade the RSI rollercoaster on time frames of less than four hours in length. This setup is designed to catch major turns in price action and it works best in range-bound markets that consistently move from overbought to oversold states. The hourly charts are simply too sensitive for the indicator, generating many false-turn signals when prices pause rather than change direction.
Adjustments for Shorter Time Frames
On the hourly charts, it is far easier for RSI to work off the temporary overbought/oversold conditions without making a true turn. Nevertheless, the setup may still be productive for shorter term traders if we add some modifications. The key to making the RSI rollercoaster successful on the hourly or shorter time frames is to never assume greater than 30-point risk on any trade.
In fact, 30 points of risk should be the maximum that the trader is willing to absorb on any one given trade. Ideally, the risk on any hourly version of the RSI rollercoaster should be no more than 15 points. This change will, of course, force traders to pass up many setups, but on the flip side they would be able to sustain three or even four consecutive losses in a row with only minimal damage to their equity; and only one good trade of 100 points or more would put the account right back into positive territory. On the hourly time frames, the signal-to-noise ratio will inevitably increase; therefore, it is vital to minimize the many likely losses in order to maintain a positive expectancy in the setup.
|Figure 4: RSI Rollercoaster, GBP/USD|
|Source: FXtrek Intellicharts|
Finally, let's take a look at the RSI rollercoaster on the GBP/USD hourly charts during the period from March 27, 2006, to March 29, 2006. We will follow the exact same rules as outlined above, with one modification: If our risk exceeds 35 points, we will not take the trade. On March 27 at 1:00am, we trigger a short sale at 1.7458, risking 24 points. The trade goes against us, and we get stopped out as the pair works off the overbought condition and trades higher. Later in the day, we get a second signal and once again go short at 1.7477. Our risk is a miniscule 10 points. We set our target at 50% of risk and cover the first part of the trade at 1.7472, moving the stop to breakeven. Once again the trade moves away from us, but we cover at our entry point, and for all intents and purposes, the trade turns into a scratch instead of another loser.
At about midday on March 28, we get a third signal to short at 1.7504. This time the risk is a more considerable 32 points, but it is just within our self-imposed risk-control rule of 35 points. We cover half the position at 1.7488, garnering 16 points, and then follow the trade all the way down to 1.7315, harvesting a very impressive 189 points on the second half of the trade. The total gain from this three-day foray into trading the pound is 162 points, but note that the vast bulk of the profits were netted from the final half position of the third trade.
In fact, that 189-point move was responsible for more than 90% of all the trading gains of the setup. The rest of the time we lost a bit or essentially broke even.
The RSI rollercoaster is a low-probability/high-reward setup. As such, it requires that the trader take as many trades as his or her risk-control rules will allow to optimize the chance of catching the one big win. The trader should also take very small, highly defined risks while waiting patiently for the big-profit trade. In the RSI rollercoaster, half the value of the strategy comes from the rules themselves, while the other half is derived from a strict money management approach.