wash trading 800x421 - How To Trade Pullbacks Using RSI and ADX

How To Trade Pullbacks Using RSI and ADX

Often times trading the cryptocurrency markets successfully entails following the path of least resistance. As a trader, we want to be in tune with the market whenever possible. One of the best ways to do that is to try to capture trend moves in the market. By combining two simple technical indicators, RSI and ADX, I will demonstrate how you can utilize a trend following approach to crypto trading by taking advantage of minor pullbacks within a trend.

Understanding the RSI Indicator

The Relative Strength Index (RSI) was created by a famous technical analyst named J. Welles Wilder. He developed this indicator along with the ADX indicator in the late 1970’s.  Wilder published his work in his book entitled “New Concepts in Technical Trading Systems”.

The RSI indicator is a momentum based indicator that measures the strength of price movement within a market. The RSI indicator is composed of just one line that fluctuates between 0 and 100.

Let’s take a look at the formula for RSI:

RSI = (100-(100/(1 + RS))), where RS is the Relative Strength.

So first we need to calculate RS, before we can get the actual RSI reading. Below is the formula to calculate RS using the default 14 period setting:

RS =  ( 14 period EMA of the prior 14 up bars / (14 period EMA of the prior 14 down bars)

Once we have the RS value we can input that variable into the RSI equation to get the RSI value.

Keep in mind that the 14 period is the typical default look back period, however, you can use any period that you would like.

There are three primary signals that are traditionally used with the RSI indicator. They are as follows:

When the RSI indicator reading is below 30, the market is considered oversold.

When the RSI indicator reading is above 70, the market is considered overbought.

When a divergence exists between RSI and Price, then a price retracement or trend change is likely to occur soon. There are essentially two main types of divergences – A Bullish divergence and a Bearish Divergence.

A bullish divergence occurs when price is moving lower while the RSI reading is diverging or moving higher.

A bearish divergence occurs when price is moving higher while the RSI reading is diverging or moving lower.

Below you will find the 480-minute chart of ETH/USD (Ethereum). Notice the circled area on the RSI indicator. These areas point to overbought and oversold signals.

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Filtering Signals with ADX

ADX stands for Average Directional Index, and it is a trend detection indicator. The ADX line helps measure the strength of a trend. It does not, however, by itself tell us the direction of the trend. ADX is often used in conjunction with the +DI and -DI lines. When you combine ADX with +DI and -DI, you can gauge the strength and direction of a trend.

Here are three basic guidelines for using the ADX study:

  • When the ADX line crosses above 25 from below and +DI is above -DI, then an uptrend is emerging or present in the market.
  • When the ADX line crosses above 25 from below and -DI is above +DI, then a downtrend is emerging or present in the market.
  • Anytime the ADX line is below 20, the market is in a consolidation, trend less market condition.

The ADX line is an excellent tool for gauging the strength of a trend. It should be utilized with other technical studies and indicators to help filter out trades within a directionless market environment. One way to do this is to only take trades when there is some volatility in the market, and the markets are moving in your intended direction.

For example, a trader could use the ADX as a trade filter by initiating a new long position only when the ADX line is above 25 and +DI is over -DI, suggesting that the market is trending to the upside. Conversely, he may elect to initiate a new short position only when the ADX line is above 25 and -DI is above +DI, suggesting that the market is trending to the downside.

Although the ADX trend filter is not perfect, it is one of the best trend detection indicators available to traders. As such, it would be wise to incorporate some aspect of it within your trading program.

Below is the 240-minute price chart of ETH/USD which shows what the ADX study looks like:

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Pullback Strategy Using RSI and ADX

Now that you have a pretty good understanding of both of these technical indicators, let’s now shift our focus to building a cryptocurrency trading strategy around these studies.

As we have discussed earlier the RSI indicator is traditionally used as an overbought and oversold signal, and traders expect a trend change to occur after an RSI reading penetrates the extreme levels of 30 and 70.

But the way that I like to use the RSI indicator is to look for areas where a minor pullback has occurred that will lead to further price moves in the direction of the overall trend. So essentially, I prefer to use it to buy temporary pullbacks in an uptrend and sell temporary rallies in a downtrend. To accomplish this, I use the threshold of 45 for buying opportunities and  55 for selling opportunities. For the look-back period I still use the default 14 period setting.

So, when the RSI line moves below 45 from above, I like to buy a few pips above the high of the first up candle. And similarly, when the RSI line moves above 55 from below,  I like to sell a few pips below the low of the first down candle created.

The above long RSI signal is valid only when it occurs in conjunction with the ADX reading above 25 and +DI is above -DI. And the above short RSI signal is valid only when it occurs in conjunction with an ADX reading above 25 and -DI is above +DI.

The stop is placed beyond the candle that signaled the entry. And for exiting the trade, I like to watch the chart for price action clues, especially a trendline breakout in the opposite direction.

RSI ADX Trading Strategy Example

Now that we have our RSI ADX trading strategy rules in place, let’s see how all this works on a real price chart.

Below you will find the 240-minute Bitcoin price chart.

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Notice to the left side of the chart the market seems to be moving lower and the RSI indicator is also moving lower along with the price action. Soon thereafter, there is some price consolidation in Bitcoin, and the RSI reading begins to move higher. Eventually, the RSI reading penetrates the 55 level as shown by the circled area on the indicator. This is our short entry signal.

Next, we must confirm that our trend filter, the ADX indicator is above 25 and that the -DI line (red) is above the +DI line (green). This is, in fact, the case, which confirms our short entry signal. We can prepare to enter a short position after the low of the first candle down is taken out.  You will see this area marked on the chart.

Our stop loss would be placed above the high of that first down candle, which never came close to being tested. And a good area to take profit would have been the upside breakout of the downward sloping trendline as shown on the chart.

 

Author: Vic Patel is the author of this guest post. He is a private trader and educator with 20+ years’ experience in the financial markets. He is also the founder of Forex Training Group.

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