This is our third article about RSI. We have already talked about RSI support/resistance breakout and divergence/convergence. To have a complete knowledge about RSI, I recommend you to read all the articles carefully:
There are three horizontal lines plotted on RSI indicator window: 30, 50, and 70
These lines work as the RSI support and resistance levels.
RSI ranges from less than 30 to over 70. When it is below 30, the market is oversold. When it is above 70, the market is overbought. I will talk about the RSI overbought and oversold territories in a separate article. In this article, I am going to talk about the 50 level that sits between the 30 and 70 levels.
RSI 50 level can be used as a strong tool to confirm the different kinds of trade setups from any trading system. Whether you use the candlestick patterns, support/resistance breakout, or any other trading system, you can consult the RSI 50 level to confirm your trade setups. Let me show you some examples.
Note: RSI’s default setting is 14, but the RSI setting we use is 9.
The below screenshot shows a strong uptrend that reverses after forming a very strong bearish engulfing pattern (the yellow zone).
Candlestick #2 goes down and engulfs the body of the candlestick #1 and its previous candlestick. For those who trade based on the candlestick patterns, this is a very strong trade setup to go short. However, those who need more confirmation, can easily use RSI(9). When the candlestick #2 which is the main candlestick in this strong bearish engulfing pattern closes and the next candlestick opens, RSI is actually below the 50 level already. This is an important confirmation indicating that the uptrend is exhausted and the bears have taken the control:
Additionally, there are already two other RSI confirmations for this strong bearish engulfing pattern:
1. RSI Divergence:
2. When the uptrend was strong and the price was going up strongly, RSI had broken above the 70 level and was moving above this level in the overbought area (the red zone). But when the strong bearish engulfing pattern formed by the candlestick #2, RSI had already broken below the 70 level and was moving almost between the 70 and 50 levels. Right when the bearish engulfing pattern was forming, RSI retested the 70 level, but it could not break above it, and it went down when the candlesticks #2 and then #3 formed. All of these RSI reactions mean that uptrend was exhausted and bears had taken the control, so that the bearish engulfing pattern formed by the candlesticks #1 and #2 was reliable enough to go short:
This is how RSI gives a strong confirmation for a candlestick pattern. RSI is a very intelligent and smart indicator, and it gives a lot of useful information about the markets. Compare the above example with so many other weak candlestick patterns that are not confirmed by RSI. For example, before the above bearish engulfing pattern, we have so many bearish candlesticks (they have a black body) formed that could be considered as bearish reversal patterns, however none of them are confirmed by RSI the way it is explained above.
Now, let’s say you either missed the above bearish engulfing pattern to go short, or you don’t trade based on the candlestick patterns, and for example you trade based on the technical analysis and support/resistance breakout. Or you consider the candlestick patterns, but you enter only when they are confirmed and followed by a technical analysis event like a support or resistance breakout.
In this case, you would not go short after the above bearish engulfing pattern, and you would do it – for example – after a support breakout. But the question is could that support breakout also be confirmed by RSI?
The below screenshot shows a small support line that was formed on the chart before the above bearish engulfing pattern. This support line was broken by the candlestick #4. You might wonder whether the support line was a valid and reliable support line, and its breakout was valid and reliable enough to go short or not. RSI and then the candlestick #5 and #6 could answer this question.
The below screenshot shows that when candlestick #4 closed below the support line, RSI was already way below the 50 level. Also, when the candlesticks #5 and #6 tried to retest the broken support line, RSI was still moving below the 50 level and was going down. Even when the price tried to retest the broken support line and the Bollinger Middle Band one more time after several days (candlestick #7), RSI was still below the 50 level. So the support breakout was confirmed by RSI, and looked like a reliable and valid breakout, specially when candlesticks #5 and #6 accurately and precisely retested the broken support line:
I am going to show you a long trade setup now.
As you see below, a resistance breakout occurred on 2012.08.03 on EUR/USD daily chart:
Let’s get closer to see how the resistance was broken and retested, and how RSI confirmed the resistance breakout and the bullish movement that took the price up for 830 pips. Follow the candlesticks numbers on the below chart.
As you see, candlestick #1 closed above the resistance line. For me, that downtrend was too strong to be reversed so easily. So I would not trust the resistance breakout if I wanted to trade based on the technical analysis and resistance breakout. I need more confirmation. RSI confirmed that the resistance breakout was valid, because it had moved up from the oversold area (the red zone) to the 50 level area and when candlestick #1 closed, RSI had already broken above the 50 level.
Just because the downtrend was too strong, the broken resistance was retested very strongly by several candlesticks, before the price goes up seriously. Look at the candlesticks #2 and #3 and the way they retested the broken resistance, and how the broken resistance worked as a strong support and did not allow any of these candlesticks to go down and close below it. Finally, candlestick #4 closed as a bullish candlestick above the broken resistance, indicating that most probably the price wanted to go up. Candlesticks #5 and then #6 strongly confirmed that bulls had taken the control. The price went up for 700 pips after the candlestick #6 formed.
While the price was retesting the broken resistance, RSI also retested its 50 level, and when candlestick #5 closed, RSI went up and never touched the 50 level anymore, which means it was the time for the price to go up strongly.
This is how the RSI 50 level help us confirm our trade setups. Try RSI(9) with your own trading system and see if it can confirm the trade setups or not.