Forex 104Lesson 3

Counter-Trend with the RSI

Trading counter to the underlying trend can be risky business – often

referred to as “catching a falling knife”, or “stepping in front of a

charging bull”. Because of this it’s important to build a case for entry.

This is done by looking for specific things to line up – known as points

of confluence. The key indicator used here is the Relative Strength

Index (RSI).

The RSI is an indicator that measures the magnitude of recent gains to losses in an attempt to measure an overbought or oversold market condition.

Having the RSI be overbought or oversold means almost nothing by itself, so it’s crucial to start layering points of confluence. The

other things we’re looking for here are:

Clear support or resistance (market structure)

A retest of this level (double top / bottom)

RSI overbought or oversold on the first test of this level

RSI divergence of the second test

Before we go any further I’ll explain the above terms, with

screenshots where appropriate.

Clear support or resistance

The first thing we’re looking for is a clear and predefined level of support or resistance. For this strategy, it’s best to consider

A higher timeframe (such as the Daily), and then drill down to a lower timeframe (such as the Hourly), to look for the double

top or bottom.

The following image shows a clear level of resistance at 1.1383 on the EURUSD Daily chart. There are multiple touches of this

level and a couple of false breaks.

Price is now back up against this level on the right hand side:

Double top / bottom

Once you’ve found a market with current price action respecting Daily support or

resistance, it’s time to drill down to the Hourly chart.

The next thing to look for is a double top or bottom. There are plenty of

different ways to define a double top or bottom, so I’ll explain a simple way I was

taught:

Consider the image of the double top below:

If the highest high of the second peak reaches the highest close of the first peak, it’s a double top.

If the second peak has a higher high and a higher close, then it’s a higher high and not a double top.

And of course if the highest high of the second peak doesn’t reach the highest close of the first peak, it’s a lower high.

In this particular situation a lower high wouldn’t necessarily be a bad thing, but we’ll focus on the

double top.

RSI overbought or oversold

Following on with our double top example: the next thing to consider

is whether the RSI is overbought on the first peak of the double top.

On most trading platforms the RSI will have the following standard settings:

14 Period Overbought = 70 Oversold = 30

I recommend the following settings, which identify more of an

extreme market condition – one which is more likely to revert to the

mean:

7 Period Overbought = 80 Oversold = 20

RSI divergence

The final thing to look for is whether we have RSI divergence when the second peak forms. All this means is when the second

peak of the double top forms, the RSI will form a second peak

as well. This second RSI peak needs to be lower than the first.

In the image above you can clearly see the second peak on the RSI is lower than 80. In the above example this is known as

‘bearish divergence’ which simply means there is likely to be

less buying pressure now.

Placing the trade

After you’ve been through the above process, and all the

criteria has been met, it’s time to place the trade.

Considering the chart above with the double top, you could

enter the trade with a sell stop pending order, or simply a

market order. I would definitely wait for the current candle to

close before entering though.

The stop loss needs to go just above the highest high of the double top. As for targets I would aim for the most recent swing

low – provided it gives you a favorable risk to reward ratio.

The image below shows the same Daily chart 3 weeks after the trade would have been placed. One

of the main advantages to using multi-timeframe analysis is that it often gives you the

opportunity to place more precise entries and stops.

In this example the risk on the trade (for a market order) was approximately 110 pips and the

reward to the next market swing low (on the Daily chart) was approximately 500 pips.

The best piece of advice I can give for this type of strategy is to understand that you need to build a case for entry. It’s not enough to just trade every

double top and bottom you see.

Look for points of confluence:

Is there clear support or resistance on a Daily chart

Is there a double top or bottom on the Hourly chart

Is the RSI overbought / oversold on the first touch?

Is there bullish / bearish divergence on the second touch?

Yes? Enter at market.

This gives you 4 points of confluence which all need to be present before you can place a trade.