Here is a simple intraday trading setup based on Relative Strength Index Indicator (RSI) technique. The chart timeframe for this intraday strategy is 3 minutes.
Interestingly, you can use this setup to trade stocks, equity indices, commodities or even currencies. Further, you can use any instrument to trade it i.e. cash (equity shares), futures or options. Also, with this strategy you can trade in a bullish as well as a bearish market.
We will use RSI Divergence technique to look for a trend reversal and a candlestick pattern to confirm the trade setup. Hence this strategy is going to be a combination of both RSI Divergence and a candlestick pattern.
There are a couple of terms we need to know before we move to the rules of the strategy. Let’s take a look at them below
Swing high - It is a point where the price makes a high, takes a pause and reverses down from the high. That high point from where it reverses is called the swing high.
Negative divergence - When price makes higher highs and RSI makes lower highs thereby creating a divergence, a negative one.
Let’s understand the step by step process as to how we analyze and trade this strategy. In this article, we will look at a bearish or short only setup.
Steps of the setup:
To understand this better, let’s analyse the Bank Nifty spot chart in the example below.
Step 1 : We are looking for a negative trend reversal. We look for a negative RSI Divergence signal after an uptrend. The idea is to enter at the start of a trend reversal at the top. We have to go to indicators and apply the ‘Relative Strength Index RSI’ indicator with default settings. The price should be making higher highs and the RSI should be making lower highs. Remember, we need to connect two high points of price and corresponding two highs of RSI. Let’s understand this with the help of an example. We will look at a price chart on the Upstox pro web platform.
Look at the points A & B on the price chart. Those points are two swing high points. If we connect point A & B, we can clearly see the price is making higher highs (B point is higher than the A point)
Now, look at the corresponding A & B points on the RSI chart below. Those are two swing high points on the RSI chart. Here, when we connect point A & B, we can spot RSI is making lower highs (B point is lower than the A point)
The price is in an uptrend and it is making higher highs and on the other hand RSI indicates in advance that the current uptrend might take a pause and we might see a trend reversal . This is called a negative RSI Divergence signal.
Step 2 : We have now got a possible RSI trend reversal signal. In order to confirm our analysis, we will have to hunt for a bearish candlestick pattern. We will only initiate the trade once we get a bearish candlestick pattern. We shouldn’t just trade a divergence. The divergence needs to be supported by a price action confirmation, in our case, candlestick pattern.
In the chart above, you can see an evening star candlestick pattern marked in a black box. It’s a three candle pattern and somewhat looks like an inverted V shape pattern. The fourth candle after the three candle evening star pattern in red is the point where we can say that a new trend can possibly start here.
This confirms our analysis. Once we get a negative RSI divergence signal and a bearish candlestick pattern, we will look to trade this setup. Now that the analysis and confirmation is done, let us see how we can trade the setup with a defined entry, exit and stop loss.
Step 3 : Let's understand with the help of a chart as to what price we enter, where to keep our stop loss and when do we exit (target)
You can see the GREEN line (38021.63) that's where we got the confirmation after the evening star pattern was formed. That is our entry point. We will enter at around those levels at 38021. Since Bank Nifty spot can’t be traded, you can look to trade Bank Nifty futures or options. If you choose to trade options, one way to go about it is that you can buy an ATM (at the money) strike price put option to trade. The market price is 38021 in our example and the nearest strike price seems to be 38000 put option. Since it’s an intraday trade, you can choose a weekly expiry rather than a monthly expiry contract.
Now, let us consider stop loss. You can see the RED line (38113.44) which is the second swing high, point B. That's 92 points above the entry point of 38021. If Bank Nifty doesn’t go down and keeps continuing its uptrend and hits 38113 (our stop loss) we will take a small loss and exit from our position.
Since it’s an intraday and a quick trade, the timeframe being 3 minutes, we will aim for a risk to reward of 1:1. In our example the risk being 92 points, we will aim for a target of 92 points from our entry price which comes to 37929 (38021- 92)
You can see the PURPLE line (37929). Once our price hits 37929, we will exit our 38000 put option position and come out with profit.
We hope this trend reversal Intraday RSI Divergence strategy was simple and easy to understand. You can try spotting it on charts and see if you are able to identify such setups.
We have covered both negative & positive RSI divergence strategies until now. We will be coming up with more such interesting intraday strategies using a combination of techniques to identify some good trade setups!
Until then, happy trading!