RSI has the usefulness of being able to measure both overbought/oversold levels and indicate the presence of a trend. Levels of 30 and 70 are generally used as default guidelines for overbought and oversold. Additionally, a value greater than 50 may indicate an uptrend, while a value less than 50 may indicate a downtrend.
These interpretations may be combined by examining potential bullish periods in which RSI is greater than 50 yet less than 70. Conversely, bearish periods may be identified as those with RSI values less than 50, yet greater than 30.
The chart shown below identifies bars according to that theory. The market shown is New York Mercantile Exchange crude oil on 33-minute bars from Jan. 2, 2008, through Aug. 15, 2008. Blue bars are those that match up with RSI levels greater than 50 and less than 70, which are generally bullish. Red bars are those with RSI levels less than 50 and greater than 30, which are generally bearish.
This concept also can be incorporated into a trading strategy. Theoretical signals from this trading system also are shown in the chart. However, a few adjustments and additions have been made to the rules.
In an attempt to cut down short-term losing trades, a neutral zone, of sorts, is created. RSI is considered bullish above 53 instead of 50, and RSI is considered bearish below 47 instead of 50. The RSI indicator above appears with the neutral zone represented by two horizontal lines, one at 47 and one at 53, instead of a single horizontal line at 50.
Long positions are closed when RSI exceeds 70, and short positions are covered when RSI falls below 30. A stop loss at $1,000 from entry is also included, and a commission of $5.32 per round turn was charged to each trade.
This concept does a reasonably good job of capturing large moves. However, the winning percentage is significantly less than 50%, indicating that there are a large number of false positives identified by the logic. Both attributes are representative of trend-following systems.
Stanley Dash is director of technical analysis for TradeStation Securities. E-mail him at email@example.com. This article does not constitute any type of trading or investment recommendation, advice or strategy on behalf of TradeStation Securities or its affiliates.