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 standard characteristic 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 a different indicator): try to think of a buying and selling strategy based on the moving averages crosses.
When there is no well-defined trend, the moving averages will continuously cross, causing you to enter and exit from the market continuously.
These continuous stops and go are considered real false signals because they continue to collect losses, 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.
When RSI is concerned, the trend is not your friend!
As we know, the market will either be trending or ranging and may not make a smooth transition from one state to the other. Each market condition requires different tools to be analyzed effectively, and when it comes to technical analysis, the one-indicator-fits-all approach does not work.
Relative Strength Index is an oscillator, and as we know, the latter group of indicators performs poorly when the instrument is trending. If we can identify as accurately as possible what the market’s state is, we could filter many of the false signals by just ignoring them when there is an uptrend or a downtrend.
MACD coming to the rescue
One great tool to use for trend identification is the MACD indicator, developed by Gerald Appel back in the 1960s.
Since our site has extensive coverage of this indicator, we will not delve into much detail about what it is and how we can use it. However, we strongly encourage you to check here for the Signal Line crossover signal and here for the multi-timeframe analysis strategy.
Moving Average Convergence Divergence is the difference between a longer moving average (usually 26 periods) from a shorter one (usually 12 periods). Their result is a line that oscillates above and below zero, without specific upper and lower boundaries. When positive, the general trend is considered bullish, and when negative, bearish.
However, for our case, we must be more specific. By adding the extra feature of MACD direction, we can identify if the trend is still intact or changed.
How to filter false signal using MACD
As a rule of thumb:
- When MACD is positive and rising, ignore any sell signals. RSI will be in overbought territory and hover around 70 for longer than usual.
- When MACD is negative and falling, ignore any buy signals. RSI will be in oversold territory and hover around 30 for longer than usual.
Let us see a couple of examples.
MACD middle pane. Fast Length = 22. Slow Length = 52
RSI bottom pane. Length = 5
From mid-November 2020, the pair resumed its downtrend making new lows till January 2021. RSI entered in oversold territory and, on December 1st, gave a false entry signal by crossing above 30. However, MACD had just started its down move below zero lines (left set of arrows). RSI reentered oversold territory and, on the 14th of December, crossed over 30 again (right set of arrows). MACD was still heading south, though, filtering this false signal again.
MACD middle pane. Fast Length = 22. Slow Length = 52
RSI bottom pane. Length = 5
NASDAQ 100 is in an uptrend on the 60 min chart. RSI is moving in the overbought zone, briefly breaking below 70, giving a sell signal, only to reenter the overbought zone after a couple of bars. A rising MACD would have kept us out of a short trade.
Thinking out of the box. Using RSI as a market trend identifier!
What if we challenge the traditional concept of RSI, reading its values from a different perspective? Is it possible to use it both as a trigger for action and as a filter at the same time? The answer is yes and let us see how we can do it.
The alternative use of RSI argues that when the market is experiencing a downtrend, the level of 60 will act as a resistance, and any upward corrections should not break above this level. In an uptrend, the inverse is true, with an RSI level of 40 offering support. Any downward correction should not break this level of RSI value.
Based on the above, the illustration that follows shows how we can interpret RSI levels as to whether we are in a bull or bear market phase.
To use RSI as a filter for false signals, we must add a second timeframe in our analysis, one level above the one we trade.
Let us walk through the whole process using the daily chart of Siemens Gamesa (GCTAF). If you want to find more about this interesting Russell 2000 stock and major pusher for a green economy, click here.
Middle pane. RSI daily, Length = 5
Bottom pane. RSI weekly, Length = 5
In the top pane we can see the daily candlestick chart of this small cap stock.
We have inserted an RSI of 5 periods in the middle pane, calculated on daily closes, and plotted as a histogram. The shaded area is the values between 30 and 70.
In the bottom pane, we have inserted an RSI of 5 periods, calculated on weekly closes (one timeframe above the one we trade or analyze, which in this example is daily), and plotted as a histogram. The shaded area is the values between 40 and 60.
Since we have a series of higher highs and higher lows, GCTAF is in an uptrend. Although RSI(5) on the daily chart fluctuates between overbought and oversold levels, RSI(5) based on the weekly closes, has never fallen below 40, verifying the uptrend too.
So according to this approach, all long signals should be followed and all short signals should be discarded.
On 23 September 2021 (1st blue arrow), daily RSI(5) crossed over 30, giving a buy signal. On the 29th of October 2021 (2nd blue arrow), another buy signal was given and would be an excellent point to add to any long position.
On the other hand, all four short signals – daily RSI(5) crosses below 70 (maroon candles) – that were given from November till December 2021 should have been discarded.
We can take from this model that an RSI value over 60, one timeframe up the one we analyze, signifies a strong bull market phase, so we should avoid any short trade. An RSI value below 40 one timeframe up the one we analyze denotes a clear bear market phase, so any long signal should be discarded.
A few thoughts regarding the last 2 filters we presented
The last two approaches are far from a complete trading system. They are set ups for a long or a short trade and special care should be given for the entry strategy. This could be a volatility stop based on Average True Range indicator, a break from a price channel etc.
Finally, the reader is encouraged to experiment with different time windows both for MACD and RSI indicators. As a rule of thumb, though, keep the former less responsive with relatively larger values for the moving averages, and the latter is more responsive, with relatively smaller values.
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.