How To Trade The RSI2 Even If You’re A Newbie

The RSI (relative strength index) is a popular trading indicator by J. Welles Wilder.

The RSI2 trading indicator is a change from the standard 14 period RSI to a 2 period that was brought to us by Larry Connors.

The other difference is the change in oversold and overbought levels:

• Overbought is >90 and the higher the better
• Oversold is considered <10 and the lower the better

Larry Connors paired the RSI2 with the 200-day moving average which would focus on the long term trend of the instrument. This would be great for position trading style however we are going to use a short to medium term trend indicator setting.

Trading Strategy Premise

Using a trend indicator (or price action to determine trend) and trading in the direction of that trend can lead to larger profits per trade.

The trick is always to discover when a good time to enter the market is present.  Using the 2-period RSI, we can determine when a markets pullback in price is far enough (long trade example) and may lead to a snap back in price.

We are banking on trends staying intact to allow us to use the RSI2 oversold and overbought levels as zones of trade entry and staying with the trade.

Due to the quickness of the period 2 setting, the RSI2 trading strategy can be adapted to a short term trading strategy simply by altering the time frame and trend indicator setting.

RSI2 Strategy Details

You can use any time frame from daily charts to 3 minute intra-day charts.

• RSI trading indicator is set to period 2
• Oversold level is set to 10
• Overbought level is set to 90
• 34 exponential moving average
• Very short term traders may want to consider a 10-period moving average

While Larry Connors suggested not using a stop loss in this trading system, I prefer using an ATR multiple for stop placement.

Experienced traders will probably want to consider price structure and I will cover some of that information as we go through some of the charts.

Buy Setups

1. Price is trading above the 34 EMA and/or the average is sloping upwards
2. 2-Period RSI pulls back and drops below level 10
3. Price can play around the moving average but strong momentum disqualifies the setup
4. Use trend line breaks, candlestick reversal patterns, or price action for trade entry

Sell Setups

1. Price will be trading below the moving average/or the average is sloping downwards
2. 2-Period RSI pulls back and rises above level 90
3. Price can play around the moving average but strong momentum disqualifies the setup
4. Use trend line breaks, candlestick reversal patterns, or price action for trade entry

Your stop loss can be virtually anything that suits your trading personality.  Since risk and tolerance for risk is personal, I will keep the stop loss above swing highs (for shorts) or over/under the setup candlestick.

2-Period RSI Trading Examples

We will be looking at overbought RSI2 so these will be short setups for this Forex trading example.  Also note that all these examples are from the last trading day before this was posted.

Since we are using pullbacks, please read:  Pullback Trading Can End In Failure | Here Is How It Happens to find what I look for in the character of a pullback to have it remain valid.

1. Price is whipping around a virtually flat moving average. Also note the lack of trending structure with the price swings (think lower highs and lows for downtrend)
2. A downtrend is obvious as price breaks lows, the average is sloping with price below.  RSI2 pulls up past level 90 and price pulls into a former support turned potential resistance zone.
3. RSI2 is overbought, price pulls back into current resistance zone.
4. Overbought RSI2, price pulls back into potential resistance zone.

Profit targets can be previous swing lows, ATR targets and even Fibonacci price targets.

Let’s take a look at day trading crude oil and consider long trades on a 5 minute chart.

1. Lazy pullback into a double bottom price structure.  The failure test on the second move is showing buyers stepping in after a short lived break of support.  RSI2 is oversold and after a period of consolidation, price rockets to the upside.
2. A complex correction (2-legged pullback) ends with another failure test of lows.  Other traders would see the green candlestick as a reversal candlestick and take the entry in that location.  Note that the RSI2 was not in oversold territory (below level 10) and you would not have take the first leg of this pullback.

Here is a one hour chart of gold futures

1. We have a strong thrust to the upside and a pullback and as noted by the red X, we never hit the oversold condition needed for a long trade
2. Price pushed up from support into resistance, a lazy pullback and we hit the oversold condition.  Trend entry can be trend line break or failed test of support
3. Price breaks from a consolidation at highs with momentum as we hit oversold.  Trend line does not break and so an entry does not occur

How about FDAX daily chart?

The RSI2 is not perfect and in this example, we will see the reality of trading.

1. Oversold in an uptrend.  Price breaches former resistance now acting as support
2. Price continues to make new highs confirming uptrend in the FDAX.  Price pulls back to former resistance and turns into support.  Price gets traction and fails at resistance
3. Pullback breaks support and is immediately regained for a strong move up
4. Oversold and price pulls back with no trigger.  Price continues to fall until buying begins, trend line break entry, and trade failure
5. Oversold pullback and you can imagine where the trend line break would occur.  Drive upwards fails and price rolls over

2-Period RSI Trading Strategy – Thoughts

Instead of the adjusted RSI, you could use the Connors RSI Using a trend determination tool will help in keeping traders from getting whipped back and forth in choppy markets.

Oversold and overbought signals do not automatically present a change in price direction.  In the chart of gold that was shown, on the left side of the chart you can see the RSI2 indicator is oversold and the market continues to decline.

Accepting that price can continue in the same direction, an entry trigger should be present.  In the article, I have shown a combination of trend line breaks and the failure test of lows (highs).

There is nothing magical about trend lines but they do show when the rhythm of the market has changed.

Failure tests are a price action entry and show where buyers or sellers (for shorts) enter the market after a breach of lows or highs.

Both of these entries are mechanical in nature which takes much of the guesswork out of your trade entry.

I am going to leave the stop loss and take profit locations for you to iron out.  Both of those will depend on the trader you are, your risk tolerance, and capital available.