Dynamic Zone RSI – Rules, Settings, Strategy, Returns
Navigating the ever-changing landscape of financial markets can be daunting, which is why traders are always seeking better technical indicators to improve their analysis of the market, — one interesting indicator is the Dynamic Zone RSI. What do you know about this indicator?
The Dynamic Zone RSI indicator is a momentum oscillator that combines the traditional RSI with volatility bands to more efficiently identify overbought/oversold zones in changing market conditions. It is similar to the conventional RSI oscillator, but rather than using the static 70/30 levels for overbought/oversold conditions, it applies a volatility band to the RSI data to spot dynamic overbought/oversold zones.
In this post, we will take a look at most of the questions you may have about the Dynamic Zone RSI indicator: what it is, how it works, and how you can improve your trading strategies with it. Read on!
Key takeaways
- The Dynamic Zone RSI indicator is a momentum oscillator that adapts to changing market conditions by combining the traditional RSI with volatility bands.
- Unlike the conventional RSI, which uses static levels (70/30) for overbought/oversold zones, this indicator uses dynamic levels based on Bollinger Bands.
- Key Features:
- The volatility band is a 20-period Bollinger Band with a modified standard deviation.
- Upper band: Marks dynamic overbought levels; RSI above this level indicates overbought conditions, even if below the traditional 70.
- Lower band: Marks dynamic oversold levels; RSI below this level indicates oversold conditions, even if above the traditional 30.
- Signal Generation: Signals are not triggered when RSI merely crosses the bands but when it reverses direction and recrosses the band:
- Bullish signal: RSI crosses back above the lower band after falling below it (exiting oversold).
- Bearish signal: RSI crosses back below the upper band after rising above it (exiting overbought).
- QuantifiedStrategies.com shows you a Dynamic Zone RSI trading strategy with trading rules and settings.
- More indicators are available if you click here: best trading indicators.
What is the Dynamic Zone RSI indicator?
The Dynamic Zone RSI indicator is a momentum oscillator that combines the traditional RSI with volatility bands to more efficiently identify overbought/oversold zones in changing market conditions. It is similar to the conventional RSI oscillator, but rather than using the static 70/30 levels for overbought/oversold conditions, it applies a volatility band to the RSI data to spot dynamic overbought/oversold zones.
The volatility band in the Dynamic Zone RSI is the usual 20-period Bollinger Bands but with a different value of standard deviation. Its upper band marks the limit level for overbought market conditions — that is, when the RSI rises above this upper band, the market is considered overbought even if that level is less than the 70 value used in the conventional RSI oscillator.
Similarly, the lower band marks the limit level for oversold market conditions — that is, when the RSI falls below the lower band, the market is considered oversold even if that level is higher than the 30 value used in the conventional RSI oscillator.
However, the RSI rising above the upper band or falling below the lower band is not the indicator’s signal. The signals are generated when the RSI crosses back below the upper band or above the lower band after going above or below the respective bands. In other words, a bullish signal occurs when the RSI crosses back above the lower band after falling below it (rises from the dynamic oversold zone).
A bearish signal occurs when the RSI crosses back below the upper band after rising above it (falls from the dynamic overbought zone).
In a chart, the Dynamic RSI might look like this (see the lower pane):
Dynamic Zone RSI trading strategy – rules, settings, and returns
Let’s backtest a Dynamic Zone RSI trading strategy that has the following trading rules:
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We backtest the S&P 500 (SPY) and we get the following equity curve since its inception until today:
Trading statistics and performance:
- Number of trades: 249
- Average gain per trade: 0.7%
- Annual returns: 5.2%
- Win rate: 78%
- Time spent in the market: 11%
- Risk-adjusted return: 48%
- Max drawdown: 14%
This is the code we used for the backtest (Amibroker):
THIS SECTION IS FOR MEMBERS ONLY. _________________ BECOME A MEBER TO GET ACCESS TO TRADING RULES IN ALL ARTICLES
CLICK HERE TO SEE ALL 400 ARTICLES WITH BACKTESTS & TRADING RULES
How does the Dynamic Zone RSI differ from the regular RSI?
The Dynamic Zone RSI differs from the regular RSI in that the former uses a volatility band applied to the RSI data to identify dynamic overbought/oversold zones. This is unlike the latter, which uses the static levels to identify overbought and oversold regions.
While the 70 and 30 levels in the regular RSI indicator mark the overbought and oversold regions respectively, in the Dynamic Zone RSI, the upper band of Bollinger Bands applied to the RSI data is used to mark the dynamic overbought zone; the dynamic oversold zone is marked by the lower band of the RSI Bollinger Bands. The zones are dynamic because the levels of the upper and lower bands change in line with the changes in market volatility.
Why use the Dynamic Zone RSI in trading?
The Dynamic Zone RSI is used in trading because market conditions are always changing. Effective market analysis requires indicators that are adaptive to the changing conditions of the market, and that is what the Dynamic Zone RSI offers. The Bollinger Bands component of the indicator ensures that changes in market volatility are factored into identifying when the market is overbought or oversold.
When the market volatility is high, the gap between the upper and lower bands widens, leading to a higher value for the upper band and a lower value for the lower band. So, the overbought and oversold zones form at higher and lower levels respectively, making it more difficult for the market to reach an overbought or oversold condition. During periods of low volatility, the upper and lower bands narrow, so the market can reach overbought or oversold conditions more easily.
How is the Dynamic Zone RSI calculated?
The Dynamic Zone RSI is calculated by using the RSI data to plot a Bollinger Band. The steps are as follows:
Step 1: Calculate the 20-period average of the n-period RSI (usually a 14-period RSI)
The formula is given as
20-period SMA RSI = {RSI[14]p1 + RSI[14]p2 + …..RSI[14]p20} /20
Where:
RSI[14]p1-20 = the value of a 14-period RSI for each period up to the 20th period
Step 2: Calculate the upper and lower bands
Upper Band = (20-period SMA RSI[14]) + nSTD of 20-period RSI[14]
Lower Band = (20-period SMA RSI[14]) — nSTD of 20-period RSI[14]
Where:
nSTD = the number of standard deviations to use for the bands. In some platforms, the default is 0.8 standard deviation, but you can set it to what you prefer — 1, 2, 2.5, or any STDs you want.
Note that the RSI[14] is plotted on the bands and the middle band, the 20-period SMA RSI line is often blanked out. So, the Dynamic Zone RSI shows the RSI line and the upper and lower bands.
What are the key features of the Dynamic Zone RSI?
The key features of the Dynamic Zone RSI are as follows:
- The RSI line: This is usually a 14-period RSI. Just like the conventional RSI, it rises when the market is going up and falls when the market is going down. It can form divergence signals too.
- The Upper Band: This is a line plotted at a certain number of standard deviations of a 20-period RSI[14] above a 20-period SMA of RSI[14]. It is obtained by adding the standard deviations to the 20-period SMA of RSI[14].
- The Lower Band: This is a line plotted at a certain number of standard deviations below the 20-period SMA of RSI[14]. It is obtained by subtracting the standard deviations from the 20-period SMA of RSI[14].
How does the Dynamic Zone RSI adapt to market conditions?
The Dynamic Zone RSI adapts to market conditions by using its volatility component to measure the market volatility and adjust its overbought and oversold zones accordingly. When the market volatility is high, the gap between the upper and lower bands widens, and when the volatility is low, the gap narrows.
Thus, during periods of high volatility, the overbought and oversold zones are shifted to the extreme ends of the indicator’s range, making it more difficult for the market to reach an overbought or oversold condition. Conversely, during periods of low volatility, the upper and lower bands come closer together, so the market can reach overbought or oversold conditions more easily.
What timeframes work best with the Dynamic Zone RSI?
The timeframes that work best with the Dynamic Zone RSI will depend on your trading style and the result of your backtesting. If you are a day trader, the options for your trading timeframe will be the hourly, 30-minute, and 15-minute timeframes.
However, to know the particular timeframes that work best for day trading, you have to backtest the various options to know the one that offers the best performance. Similarly, if you are a swing trader, you may have to focus on the 4-hourly and daily timeframes and backtest them to find the right one for your strategy.
Can beginners use the Dynamic Zone RSI effectively?
Yes, beginners use the Dynamic Zone RSI effectively if they understand how the indicator works and use it appropriately. To learn how to use the indicator, a beginner should read about the indicator and then open a demo account to practice with the indicator.
When they are familiar with how it works, they can formulate strategies with it and backtest them. They can then continue their trading practice with strategies that show positive expectancy.
What are the overbought and oversold levels in Dynamic Zone RSI?
The overbought and oversold levels in Dynamic Zone RSI are not static values, as in the regular RSI. Rather, they are dynamic, changing with changes in market volatility. The dynamic overbought zone is marked by the upper volatility band of the indicator — the area above this upper band is considered overbought. Likewise, the area below the lower volatility band is considered the dynamic oversold region.
The levels adapt to changes in market conditions, shifting towards the extreme during periods of high volatility and becoming less extreme during periods of low volatility.
How do dynamic zones improve RSI performance?
The dynamic zones improve RSI performance by adapting the RSI overbought and oversold signals to the prevailing market conditions, such that when there is low market volatility, the Dynamic Zone RSI can signal overbought or oversold conditions before the 70/30 RSI levels.
On the other hand, during periods of high volatility, the overbought signal may come even beyond the 70 RSI level, and the oversold signal may come even well below the 30 RSI level.
How can Dynamic Zone RSI help with trend identification?
The Dynamic Zone RSI may help with trend identification by moving in the direction of the trend. When the RSI line is rising, the trend is up, and when the RSI line is falling, the trend is to the downside. However, being a momentum oscillator, the indicator can only identify short-term trends or price swings.
There are better indicators for identifying medium-term and long-term trends, such as the moving averages.
What trading strategies work well with the Dynamic Zone RSI?
The trading strategies that work well with the Dynamic Zone RSI include mean-reversion strategies and trend continuation swing trades. Basically, any strategy where you can use the regular RSI works even better with the Dynamic Zone RSI.
For example, you can use the RSI to know when a pullback is losing momentum so you can enter the next impulse wave that will continue the trend. You can do the same more effectively with the Dynamic Zone RSI as it even adapts to the market condition.
How do you set up Dynamic Zone RSI on a trading platform?
To set up Dynamic Zone RSI on a trading platform, go to the indicator section of the platform and search for the indicator. If it is there, you double-click on it and drag it to the chart. However, it may not be there if it is preinstalled on your trading platform.
In that case, you have to find a custom-made version for your trading platform and install it first before you can set it up.
Is the Dynamic Zone RSI suitable for day trading?
Yes, the Dynamic Zone RSI can be suitable for day trading if used with a profitable strategy and traded on the right timeframe. The most suitable timeframes for day trading are intraday timeframes, like the hourly, 30-minute, and 15-minute timeframes.
If the indicator is used to create a trading strategy that has been proven to have an edge on any of these intraday timeframes, then, it can be suitable for day trading.
How does Dynamic Zone RSI handle market volatility?
The Dynamic Zone RSI handles market volatility by adjusting the levels of its upper and lower volatility bands in line with the changes in market volatility. Those upper and lower bands get more extreme levels when the market volatility is high and less extreme when the market volatility is low.
Since those upper and lower bands determine the limits of the overbought and oversold zones respectively, the indicator can be said to adapt to changes in market volatility.
What are the advantages of using Dynamic Zone RSI over other indicators?
The advantages of using Dynamic Zone RSI over other indicators include the following:
- The Dynamic Zone RSI adapts to the prevailing market condition by shifting the levels of its overbought and oversold bands in response to changes in market volatility.
- The indicator can be used to formulate entry signals.
- It can be used in any financial market since it is based on price data alone.
How can Dynamic Zone RSI be used in combination with other indicators?
To use the Dynamic Zone RSI in combination with other indicators, you have to understand how the indicator works so as to know other indicators that can complement it. Being a momentum oscillator, the Dynamic Zone RSI can be used with trend indicators and tools, such as moving averages and trendlines, as well as support/resistance indicators.
In a trending market, you can use the moving average or trendline to identify the direction of the trend and use the Dynamic Zone RSI to track the price swings. Specifically, you want to know when a pullback swing is over so that you can trade the next impulse swing in the direction of the trend. For instance, let’s say the moving average shows the main trend is up. If the price pulls back to a support/resistance level and the Dynamic Zone RSI shows an oversold signal, it could be a good setup for a long position.
What signals does the Dynamic Zone RSI provide to traders?
The Dynamic Zone RSI provides the following signals to traders:
- Overbought/oversold signal: An overbought signal occurs when the RSI line crosses above the upper band into the overbought territory and then falls below it. It is a bearish signal. An oversold signal occurs when the RSI line crosses below the lower band into the oversold territory and then rises above it. It is a bullish signal.
- Divergence signal: This occurs when the indicator swings and the price swings are out of phase. When the price is making a lower low but the indicator is making a higher low, there is a bullish divergence signal. Conversely, when the price is making a higher high but the indicator is making a lower high, there is a bearish divergence signal.
Can Dynamic Zone RSI reduce false signals in trading?
Yes, the Dynamic Zone RSI can reduce false signals in trading but not in all situations. The indicator adapts to prevailing market conditions by adjusting its overbought and oversold levels in response to changes in market volatility.
However, it does not mean that the indicator is infallible. It can still and does give false signals like all other indicators out there.
How do you interpret Dynamic Zone RSI signals?
To interpret Dynamic Zone RSI signals, you have to consider the market structure and the direction of the main trend. The indicator showing an overbought signal does not mean that the market will start selling if the market is strongly trending upward. The same is true for an oversold signal in a strong downtrend.
You use the overbought/oversold signals to identify the potential end of a pullback in a trending market. So, in an uptrend, you look for oversold signals to ascertain a potential end of a pullback, and in a downtrend, you look for overbought signals to ascertain a potential end of a price rally.
What is the best way to optimize Dynamic Zone RSI settings?
The best way to optimize Dynamic Zone RSI settings is to forward-test the indicator and evaluate your trading results after a certain sample size of trades has been reached. This way, you adjust the settings based on what works in live market conditions.
The alternative is to backtest the indicator with in-sample data and optimize using out-of-sample data.
How does the Dynamic Zone RSI respond to sideways markets?
The Dynamic Zone RSI responds to sideways markets by narrowing the gap between the upper and lower volatility bands if the market volatility is low and widening the gap if the volatility is high.
In a low-volatility market, the RSI line will have less distance to move to reach the overbought or oversold level, but since its movement is slowed by the low-volatility condition, it balances it out.
How can Dynamic Zone RSI be used in risk management?
The Dynamic Zone RSI cannot be directly used in risk management since it does not show the level of a stop-loss order or how much position size to use in a trade. However, it can be used to create a robust trading strategy with a clear entry and exit strategy, as well as a risk management plan.
What common mistakes should traders avoid with Dynamic Zone RSI?
The common mistakes should traders avoid with Dynamic Zone RSI include:
- Trading without a clear entry and exit strategy
- Using the indicator as a standalone strategy
- Trading without a clear risk management plan
Where can you find Dynamic Zone RSI for backtesting and strategy development?
Where you can find Dynamic Zone RSI for backtesting and strategy development will depend on the trading software you are using. If the indicator is already preinstalled in the software, you can use it there to create your strategy and backtest it.
But if it is not already preinstalled, you may have to get a programmer to create a custom version for your trading software and code the strategy you develop with it for backtesting.