The Relative Strength Index (RSI) is among the common and most powerful technical indicators widely used by professional traders and investors when analyzing financial markets. This index has been used by traders to make crucial decisions since it was initiated by J. Welles Wilder in 1978. When trading CFDs, the RSI indicator can be very helpful in helping traders make crucial trading decisions.
If you’re keen to learn more about RSI and how it is used in CFD trading, this article is for you. In this article, we will explore how the RSI indicator is used in CFD trading, revealing how it can help traders make informed decisions and potentially enhance their trading outcomes both in the short term and in the long term. Whether you’re new to trading or a seasoned trader, this guide will help you get better in your trading endeavors. Without further ado, let’s dive right in!
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Introduction to RSI Indicator
What is the Relative Strength Index?
The Relative Strength Index (RSI) is a popular momentum indicator used to measure the magnitude of gains or losses on a given security in a given period (days). The main goal of the RSI indicator is to enable traders to evaluate whether a security is overvalued or undervalued. The RSI is represented as an oscillator on a scale from 0 to 100.
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It can provide insights beyond just identifying overbought or oversold conditions. For instance, the RSI can also indicate when a security is likely to undergo a trend reversal or a corrective pullback in its price, providing valuable buy and sell signals to traders. Overall, this indicator is a very useful tool that every trader needs to leverage to make better decisions.
What is a CFD?
A Contract for Difference (CFD) is a financial contract between a buyer and a seller that’s based on the difference between the current value of an underlying asset and its value at the time the contract is established. This method of trading has been around since the 1980s, and it has enabled traders to profit from the price movements of various derivatives.
CFDs allow traders and investors to speculate on the price movements of various assets, such as stocks, commodities, currencies, and indices, without actually owning them. With CFD, you don’t own the financial asset itself; you’re simply making a contract with a broker to settle the price difference between the contract’s opening and closing. At the end of the contract, you will either make a profit or loss depending on whether the speculated value difference of the asset was right or wrong.
When you are trading CFDs, it’s important to know that CFD trading is a zero-sum game. What you gain or lose, is someone else’s loss or gain.
Understanding RSI Trading Strategies
How to Use RSI as a Trading Indicator
As stated earlier, the Relative Strength Index (RSI) is a powerful trading indicator that offers versatile applications for traders. Two of the most popular ways to use the RSI involve identifying overbought and oversold conditions and creating mean-reversion trading strategies. Let’s explore the details
Identifying Overbought and Oversold Conditions
The RSI operates on a scale from 0 to 100 and is frequently used to determine whether a security is overbought or oversold. A low RSI reading (typically below 30) indicates that the asset’s price may have fallen significantly and could be oversold. On the other hand, a high RSI reading (usually above 70) suggests that the asset has experienced a substantial price increase and might be overbought.
RSI = 100 – [100 / (1 + RS)], where RS = (Average Gain / Average Loss)
The RSI formula calculates these conditions by averaging gains and losses over a specified period, typically 14 days. This calculation results in an RSI reading that oscillates between the two extremes.
Creating Mean-Reversion Trading Strategies
Mean-reversion strategies aim to profit from price movements that tend to revert to their average or mean over time. RSI is an excellent tool for developing these strategies. Traders set specific thresholds, such as values above 70 for overbought and values below 30 for oversold.
For example, if the RSI surpasses 70, it might indicate that an asset is overbought, and a price correction could be on the horizon. On the other hand, when the RSI drops below 30, it could signal an oversold condition, potentially representing a buying opportunity.
Applying RSI Settings for Day Trading
When applying RSI settings for day trading, it’s important to recognize that there are no one-size-fits-all standard values for the RSI thresholds. The ideal settings can vary depending on several factors, including the asset class, the chosen time frame, the prevailing market trend, and the desired responsiveness of your trading strategy.
For day trading with the RSI, it’s often beneficial to use shorter time frames. This approach involves using more extreme threshold values. For instance, you might consider using 15 as the threshold for identifying oversold conditions and 85 for overbought conditions. Shorter time frames provide a higher level of sensitivity, which is very crucial in day trading.
In this context, a common buy signal occurs when the RSI reading drops to 15 or less, signifying an oversold condition and a potential buying opportunity. On the other hand, if the RSI reading exceeds 85, it’s seen as a bearish signal, indicating that the asset is overbought, and it may be a good time to consider selling.
Identifying the Best RSI Settings for Your Trades
RSI settings can significantly impact the effectiveness of your trading approach. Since there are no fixed, universal settings for RSI, traders must personalize these settings to align with their specific trading goals and preferences. For day trading, it’s common to opt for shorter time frames when setting RSI thresholds.
Shorter time frames, like 15-minute or 30-minute intervals, are favored because they provide a more sensitive and timely response to market changes. In such cases, setting RSI thresholds at 15 for identifying oversold conditions and 85 for overbought conditions can be effective.
This concept is straightforward: an RSI reading of 15 or below often indicates that an asset is oversold, potentially presenting a buying opportunity. Conversely, an RSI reading above 85 may signal that the asset is overbought, prompting traders to consider selling. However, it’s crucial to keep in mind that shorter time frames may result in more erratic RSI readings, given their heightened responsiveness.
On the other hand, if you extend your time frame to longer intervals, the RSI readings tend to be smoother and exhibit less volatility. The choice between shorter or longer time frames should align with your trading strategy, risk tolerance, and the asset class you’re trading.
There is only one way to find out what works or not: via backtesting. This website is all about quantifying trading rules to backtest them.
Popular RSI Trading Strategies in CFD Trading
These are three popular RSI Trading strategies that CFD traders might implement to enhance their chances of success.
- Two-Day RSI Strategy
In CFD trading, the two-day RSI strategy can be a valuable tool for traders looking to capitalize on short-term price movements. This strategy relies on the Relative Strength Index (RSI) to identify potential buy and sell signals. When the two-day RSI crosses below 10, it suggests that the underlying asset may be oversold, indicating a potential buying opportunity for CFD traders.
On the other hand, when the RSI crosses above 80, it signals that the asset might be overbought, indicating a possible selling opportunity. Traders can apply this strategy to various CFD assets, such as stocks, commodities, or indices, with a focus on short-term movements. However, it’s essential to consider the specific asset’s characteristics and market conditions when implementing this strategy in CFD trading.
This strategy only works on assets that are prone to mean reversion. In stocks, this has worked great since futures trading started in the early 1980s.
We backtested the above trading rules for SPY, the ETF that tracks S&P 500 and is the oldest ETF still trading. This is the equity curve for this particular trading strategy:
The 313 trades returned 0.86% per trade. That is acceptable, but you experience pretty hard drawdowns along the way. Most CFD traders would probably be wiped because of that.
Is this enough to make a profit for trading the CFD that tracks SPY? That depends on the spread and your broker and is impossible to backtest.
- Improved Two-Day RSI Strategy (Using Qs Exit)
This enhanced two-day RSI strategy with the QS exit mechanism can also be beneficial for CFD traders. By buying when the two-day RSI crosses below 10 and selling when the close is higher than yesterday’s high, this strategy offers better risk management and smoother equity curves. In the context of CFD trading, where leverage is often involved, mitigating risk is crucial.
This strategy’s focus on risk-adjusted returns makes it suitable for traders who aim to limit potential losses while seeking opportunities in CFD markets. CFD traders can apply this strategy to various assets and adapt it to the specific characteristics of the CFD market they are trading.
Let’s backtest the strategy with the new sell trigger:
The number of trades increases to 355, but the average gain per trade drops to 0.67%. But the good news is that the erratic drawdowns are smaller and smoother.
- RSI Momentum Strategy
CFD traders interested in trend-following strategies may find the RSI Momentum strategy relevant. This strategy identifies and capitalizes on bullish regimes in CFD markets, entering long positions when the market exhibits a bullish trend and exiting when the trend weakens. While this strategy generated fewer signals, it can still be useful for CFD traders looking to participate in longer-term trends.
By using the 100-day look-back period and a 14-day RSI indicator, traders can adapt the strategy to suit the specific CFD assets they are trading. It’s important to consider the asset class and market conditions to determine the most appropriate time frames and settings.
Tips for Optimal RSI Trading Using CFD – FAQs
Combine RSI with Other Indicators
The RSI is a powerful tool, but it works best when used in conjunction with other indicators or variables. Many successful CFD traders combine RSI with factors such as volume, relative performance to other assets, or unique criteria that fit their trading style. Experiment with different combinations to enhance the effectiveness of your CFD trading strategy.
Backtesting Is Key
In trading, backtesting refers to testing a predictive model on historical data. Backtesting is essential to validate the efficacy of your RSI trading strategy. It’s not enough to rely on past performance; you must systematically test your strategy with historical data to assess its predictive value. Ensure you conduct backtests with the specific asset classes you intend to trade with CFDs.
Time Frame Matters
The choice of time frame significantly influences the success of your RSI trading strategy. Shorter time frames, such as two or three days, tend to work better for the RSI, especially for stocks. Longer time frames might lead to more volatility but may produce bigger profits. Adapt your strategy based on the specific CFD assets and market conditions you are trading.
Diversify Threshold Settings
There are no universal threshold values that guarantee success with RSI trading. The threshold values for overbought and oversold conditions depend on the asset class, time frame, and market trend. In general, shorter time frames work better with more extreme threshold values, like 15 for oversold and 85 for overbought. Adjust your settings based on the specifics of your CFD trading strategy.
Combine Time Frames
Combining different time frames can be an effective way to trade with RSI. For instance, you can use a longer-term RSI to determine the broader trend and a shorter-term RSI to identify entry points during short-term pullbacks.
However, you must be cautious, as the combination of time frames may not always result in better performance, as shown by the backtesting results.
Keep an Eye on RSI Divergences
RSI divergences can be a strong signal for CFD trading. Bullish divergences occur when the price sets a new low while the RSI doesn’t, signaling a potential buying opportunity.
Bearish divergences happen when the price sets a new high while the RSI doesn’t, indicating a possible selling opportunity. While these divergences are more challenging to quantify and program, they are worth considering in your trading strategy.
Prioritize Risk Management
Finally, effective risk management is crucial when trading CFDs with the RSI. Pay attention to factors such as commissions, slippage, and taxes. Consider setting stop-loss orders to limit potential losses and protect your trading capital. That said, most trading strategies perform worse with a stop loss. This is a problem in CFD trading where leverage is huge.
Conclusion – CFD Trading
In summary, CFD trading involves profiting from price differences in financial assets such as stocks, indices, or currencies, all without assuming the risk of owning them. When combined with RSI, CFD traders can leverage the RSI’s ability to identify overbought and oversold conditions and develop mean-reversion strategies.
The RSI’s flexibility permits the creation of diverse trading strategies depending on chosen time frames and thresholds. For effective CFD trading, it is also essential to blend RSI with other indicators and to conduct comprehensive backtesting to validate your strategy’s performance before implementation.