Using a Moving Average with RSI: Another way to create a signal from RSI

Have you ever been frustrated with RSI? How many times does it fail to reach those overbought and oversold areas? When it does, quite often price just continues. Well, there is another technique, not very exact but can be useful. It is possible to draw a trend line on RSI.

Let's look at this:

In this daily chart of the Euro-Dollar I have plotted an RSI and have added to this a 7 period moving average. Firstly you can see that the RSI itself has never reached oversold while on two occasions has just brushed overbought. Clearly the signals from RSI are weak at the very least.

What if we try and consider trades when the RSI breaks through the moving average?

I have highlighted major breaks and it can be seen that if we had traded in this way without any other signal we would have seen some bad trades and some pretty good ones too. However, we really would like to filter out bad trades. Quite often these can offset any profits we make.

Let's first review the definition of a trend.

An uptrend is when both price highs are moving higher and price lows are also moving higher.
A downtrend is when both price lows are moving lower and price highs are also moving lower.

With this definition then it suggests that before we can confirm a reversal we need to see the last major high breached in a move lower or the last major low is breached in a move higher.

Look at Point 1 where price has been rising but during this rally there has been a brief period of choppy price action but which has maintained the sequence of higher highs and higher lows. During this period RSI has oscillated around its average. It would be possible to avoid selling on the crosses lower unless price broke below the last major low. It never did. Whether we would have kept with a long position is uncertain but certainly we could attempt to buy the crosses higher once price has penetrated above the last major high.

At Point 2 we have seen a reversal lower in price but at this point there is a sharp correction higher which forces RSI above its average. However, once again price fails to confirm that signal by failing to break above the last major high.

At Point 3 there is a similar situation as at Point 2. It is likely that we may have taken a bad trade here as price did just break above the prior high. Signals are never perfect.

At Point 4 we had the same situation as at Point 2. The correction in price is deep and would have probably hit a trailing stop at some point but we would have still taken a small profit. However, since the last major high was much higher we would have avoided getting whipped out of our position.

Finally at Point 5 we have the opposite, a rally in which a price correction lower has forced RSI below its average. Here the situation is a little mixed since there was a previous correction lower and when RSI broke below the average it did move a few points below the previous low. It is possible that we may have gone short but the subsequent buy signal after RSI broke back above the average would have been very profitable.

This is a very simple example and only using a daily chart. When trading this in reality it is always advisable to do other analysis in the shorter term charts to confirm the larger signal. Alternatively it is possible to subscribe to a commentary service with reliable support and resistance levels to get a professional opinion on what constitutes a reversal (or continuation) of a trend.

To get an average drawn in Dealbook, go to the Chart Studio and open up the RSI indicator. You will be able to create a new indicator (say RSI Average) and save it. You should make the following changes:

1. Name the indicator "RSI_Average"
2. Add an additional plot in the "Draw" line called Avg("Average")
3. Below the last line of text, but above the last "end." Add: Avg := sma(line, 7);

This is shown below with the changes highlighted.

indicator RSI_Average;
input price = close, period = 14, hi_baseline = 70, lo_baseline = 30;
draw line("RSI"), Avg("Average"), line_hi("Overbought"), line_lo("Oversold");
vars i(number), u(series), d(series), au(series), ad(series), dif(number), f(number);
begin
  line_hi := makeseries(front(close), back(close), hi_baseline);
  line_lo := makeseries(front(close), back(close), lo_baseline);
  f := front(price);
  u[f] := 0;
  d[f] := 0;
  for i := f + 1 to back(price) do begin
    dif := price[i] - price[i - 1];
    if dif > 0 then begin
      u[i] := dif;
      d[i] := 0;
    end else begin
      u[i] := 0;
      d[i] := -dif;
    end;
  end;
  au := mma(u, period);
  ad := mma(d, period);
  line := 100 * au / (au + ad);
  Avg := sma(line,7);
end.

Then in the top menu bar click on "Build" and then "Verify"
You will be asked to provide a name. You may use "RSI Average"
Then click on "Build" again and this time choose "Install"

This should now be ready to use within the charts in Dealbook.

Good luck

Ian Copsey
Global Forex Trading
http://www.gftforex.com