The Secret RSI Strategy for Determining Breakouts

Published: Sat, 01/23/16

RSI Strategy For Determining Breakouts

Price action can be classified into two general conditions - range bound and trending.

A range bound market tends to remain between defined support and resistance levels and fails to trade to new highs or new lows. A trending market on the other hand tends to trade to new highs or new lows and may extend for a significant period of time. As the market approaches a significant high we may either decide to sell anticipating the range to continue or buy anticipating a breakout.

In such situations it becomes a difficult task to determine if the current range will continue or a new trend will emerge?

Here we can use the RSI to help us in our quest.

The RSI is very well suited for this, because of its ability to normalize price data providing a much smoother and often better picture of the true price action.

In fact, in FX where volume data is usually not available, the RSI can be used as a proxy for volume with large upward spikes in RSI indicating strong buying.

The RSI plotted on a scale of 0-100 measures the current market price in contrast to its average price, and helps us identify relative overbought and oversold conditions

Typically a reading above 70 indicates an overbought state, and a reading below 30 indicates oversold regions. In a range bound price action, we would typically go long as the RSI dips below 30 and crosses back above it, and take short positions as the RSI rises above 70 and crosses back below it. This approach generally tends to generate profitable returns as the FX markets tend to remain in a range the majority of the time.

However, as the market breaks out of its range to a new trend and as the RSI crosses above 70, the market will also break resistance and trade to new highs.

Hence, if we have an indication of a breakout we should look for confirmation not only on the RSI but also in the price action.

We may define the parameters of this strategy as -

  • If the RSI breaks above 70 and the market fails to break above a resistance level the current range will tend to continue.
     
  • However if the market trades to new highs breaking a previous resistance level as the RSI crosses above 70 a new trend or a continuation of the trend to the upside is strongly indicated.

Trading these simple horizontal trend line breaks, which denote support and resistance, provide us with high-probability set-ups.

The following chart example shows this strategy

Forex

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