Would you like to learn our best tricks to avoid RSI false signals? This article will explain the critical problems of an RSI-based strategy and how to solve them.
In this article, you will learn some of our best tricks. You will understand how to avoid the classic mistakes and limit the false signals of the Relative Strength Index Indicator.
The false signals of an RSI
Let’s start by defining a false Relative Strength Index Indicator signal because many novice traders are not clear about this concept.
Many traders consider false signals the regular movements of an oscillator, which is not optimal for perfect market entry timings. Also, the stochastic indicator or the Chande Momentum belongs to the oscillator family:
Let us give you an example of a false signal (with another indicator): try to think of a buying and selling strategy based on the intersection of two moving averages.
When there is no well-defined trend, averages will continuously cross, causing you to enter and exit from the market continuously.
These continuous stops and go are considered real false signals, but this is not precisely what happens in a strategy based on the RSI indicator.
With that in mind, try to think about what happens when a Relative Strength Index Indicator breaks the oversold area and immediately goes back while the price doesn’t start to go down.
This is not a false signal as with the example of the moving average because, despite entering the market, you have not yet gone out either in profit or in a loss.
The indicator was actually in an oversold area, and therefore, your entry was correct based on strategy. Many strategies involve studying and identifying divergences between the RSI line and the price. There are techniques to identify bullish divergence, and there are many indicators for MT4 for automatic divergence detection.
Generally, we don’t like to use a stop & reverse strategy based on a Relative Strength Index Indicator because it would not make much sense, especially in today’s markets.
Maybe one strategy can work on the US S&P500 index with RSI stop & go strategy: the Larry Connors 2-period RSI strategy.
In fact, a two-period RSI is much more responsive and lends itself better to providing much faster entry and exit from the market.
By shortening the Relative Strength Index Indicator period, however, you will get more false signals this time because the RSI could move erroneously, especially on low time frames.
See what a graph with a 2-period RSI looks like; as you see, it continuously switches from an overbought zone to an oversold zone.
If you want to deepen this strategy, you can read our article: LINK.
Returning to the example of moving averages, there are many tricks to use to limit false signals. Simultaneously, with the Relative Strength Index Indicator, it becomes challenging to intervene on the indicator.
This does not mean that it is impossible to improve, but we will have to act on several fronts to better the market entries.
The timing is the major weakness of an RSI-based system; below, we will show you how to improve this aspect by adding further elements into your strategy.
Avoid RSI false signal when the trend doesn’t reverse
When the RSI exceeds the overbought or oversold threshold, it can continue to rise or fall for an extended period without prices reversing the trend.
An oscillator is not a very reactive indicator and can remain in an area of overbought or oversold for even long periods.
Look at what has happened on the American index in this period: the Relative Strength Index Indicator generated a signal on SPY Etf, and then the prices continued to rise for another long period.
As we have previously explained, this is not a real false signal but only a characteristic of the indicator.
The point is that passing an overbought or oversold zone is not a clear signal to open a trade, so in a nutshell, it’s just a timing issue.
Regarding the timing of entry, it would be useless to intervene on the indicator, preferring to adopt price-based solutions.
For example, delaying entry pending a specific pattern may break a minimum or a maximum period or the intersection of two moving averages.
Insider tips: the RSI exceeds 70 and enters the overbought area. Instead of entering the market immediately with a short, it would be preferable to wait for a confirmation pattern.
We could wait for a weekly minimum to break, which could occur many candles after the RSI input signal.
When a critical minimum breaks, the price speeds up, allowing you to immediately bring the trade into profit and manage the position with less stress.
Another solution to limit false signals could be to insert two moving averages on the price chart and wait for the faster average’s downward crossing.
This is a classic system widely used to enter the market and can work well in this context.
These are just two ideas that we have experimented with in our systems that improve the strategy’s performance.
Besides improving all the statistics overall, they lower the number of trades and also reduce the time spent on the market.
The price sideways after the entrance signal
The second characteristic false signal of the Relative Strength Index Indicator is when the indicator exceeds an overbought or oversold threshold, but then the price starts to lateralize.
Look at this example:
The indicator has passed the threshold of 70 and is, therefore, in an overbought condition generating a trade signal.
Subsequently, the price sideways, but the indicator falls, then after many weeks, it returns to an OverBought area.
However, this is a characteristic of the indicator; in fact, an oscillator moves both when the price has a clear direction and when the price sideways.
Limiting this problem is complicated because it becomes complicated to filter this situation compared to the previous one.
When the RSI signals the market entry, the price could:
- keep moving in the same direction, and we will have a loss
- turn the tide, and we will be in profit
- lateralize, and we would be stuck inside a trade
We do not use filters to avoid this false signal, but we will act on trade management. We set a maximum duration limit for the trade within which the transaction will be closed at a loss or a profit.
In this way, we will avoid staying on the market for long periods when the conditions for entering the market no longer exist.
With this simple trick, we will perform backtests and decide how long to give the trade before it is closed; we will also be able to analyze the maximum excursion of profit and losses during the operation.
Let’s now see other minor tricks that could allow us to make our RSI indicator perform better and avoid false signals.
Use a smoothed version of the indicator to avoid RSI false signals
We have built many systems using this trick. We love creating smoothed indicators because they allow you to filter false signals due to price nervousness.
What is a smoothed Relative Strength Index Indicator?
A smoothed RSI is constructed by averaging the values of the indicator. A 5-period moving average of the RSI indicator is created and used in place of the indicator.
We can use this system with all indicators and even with market prices. You will filter many false signals.
Filtering the false signals of an RSI is even more critical the more you go down in timeframe. An intraday trader should use this kind of RSI for his strategy system.
Look at the difference between a standard RSI and a Smoothed RSI; the line is much less nervous. You can also edit.
The changed indicator will avoid entering the market because of an erratic movement; a more important move involving five candles will be necessary.
We remind you that the indicator comprises a moving average that considers the RSI values of the last five candles.
This trick is handy in low time frames where the nervousness of prices is sometimes excessive.
More about RSI from Investopedia Website: Click here.