Hey there, trading enthusiasts! Today, I’m excited to share with you a straightforward yet incredibly effective trading strategy that I’ve personally used for quite some time. Trust me, it’s not just another strategy – it's one that has consistently delivered profits. If you apply it correctly, the success rate is remarkably high! The best part? You only need two simple indicators: a 200-period Exponential Moving Average (EMA) and a 14-period Relative Strength Index (RSI).
Intrigued? Let’s dive right in!
The Foundation of this Trading Strategy
At the heart of this strategy is a fundamental observation: in a strong uptrend, the RSI typically stays above the 50 level, only dipping below it for brief moments before coming back above 50. Conversely, in a strong downtrend, the RSI remains below 50, with occasional moves above it that don’t last long.
Why is this important? Because if we can identify these patterns, we can time our trades to ride the momentum of the trend!
In the image above, you can see a stock in a robust uptrend. Notice how the RSI indicator (the wavy line below the price chart) mostly stays above the 50 level, with only brief dips below it. After each dip, it quickly rebounds above 50, confirming the strength of the uptrend.
Now, take a look at the image above. Here, the stock is clearly in a downtrend. The RSI indicator stays below the 50 mark for most of the time, occasionally peeking above it, but soon returning below. This behavior shows a persistent downward momentum.
Key Insight: When to Enter the Trade
Based on this pattern, if you open a buy position when the RSI crosses above 50 (in an uptrend) or initiate a sell position when it crosses below 50 (in a downtrend), you stand a good chance of making profitable trades. But remember – this strategy doesn't work in al markets.
Beware of Sideways Markets
Not all markets are ideal for this strategy. In a sideways or range-bound market, the RSI will frequently cross above and below the 50 level, which can lead to false signals and potential losses. That’s why this strategy should only be applied in strong uptrends or downtrends. Don’t worry – we’ll explore exactly how to identify these trends in the next steps.
Breaking Down this Trading Strategy – Step by Step
I’m going to guide you through this strategy step-by-step. Each step is crucial, so don’t skip ahead!
Step 1: Identify the Trend
The first step is to determine whether the market is in a strong uptrend or downtrend. This is where the 200-period EMA comes into play. If the price is trading above the 200 EMA, and the EMA itself is slanting upwards, it signals an uptrend. The steeper the slope, the stronger the uptrend. Conversely, if the price is below the 200 EMA and the EMA is slanting downwards, it indicates a downtrend.
To further confirm the trend, check the higher timeframes (like weekly or monthly charts). Strong trends tend to be consistent across multiple timeframes. Once you’ve confirmed the trend direction, your task is to screen stocks that meet these criteria.
Step 2: Confirm the Trend’s Strength
Now that you’ve identified the trend, you need to ensure that it is not weakening. Look for any divergences between the price and the RSI. For example, if the price is making higher highs while the RSI is making lower highs, it could indicate that the trend is losing momentum. Similarly, check for divergences between the price and the MACD (Moving Average Convergence Divergence) indicator. If you don’t see any signs of weakening, proceed to the next step.
See in the above image that the stock is showing Price RSI divergence and afterward RSI goes above 50 giving a false buy signal and the stock goes down afterward. You would have been at a loss had you not spotted the divergence.
Step 3: Enter the Trade
This is the exciting part – entering the trade! In an uptrend, wait for the RSI to cross above the 50 level. Once it does, you can enter a buy position, riding the wave of the uptrend. In a downtrend, wait for the RSI to cross below 50. When it does, enter a short sell position to capitalize on the downward momentum.
Step 4: Set Your Stop Loss
Every successful trading strategy includes a plan for managing risk. A stop loss is essential to limit your potential losses in case the trade goes against you. In this strategy, place your stop loss at the most recent swing low as shown in the pic above. This ensures that you are giving the trade enough room to breathe while protecting yourself from a major reversal.
Step 5: Define Your Target
Now, it’s time to set your profit target. There are two ways you can do this: using a trailing stop loss or applying the Fibonacci extension tool. As the trade moves in your favor, you can trail your stop loss to lock in profits. Alternatively, you can use Fibonacci levels to identify potential price targets. If you notice signs of trend weakening, such as divergences, consider liquidating part of your position to secure gains. For the remaining portion, tighten your stop loss to maximize profits as long as the trend continues.
This strategy is particularly effective for swing traders, and it can be applied across various timeframes – whether you’re trading on a weekly, daily, or even an intraday basis.
Stay tuned – your trading game is about to level up!
Further reading-
1) Trend Identification with the Relative Strength Index (RSI) Technical Indicator – A Conceptual Study Panigrahi A K, Vachhani K, Chaudhury S K, Trend Identification with the Relative Strength Index (RSI) Technical Indicator – A Conceptual Study, Journal of Management and Research Analysis, 2021;8(4):159-169
2) Forecasting system approach for stock trading with relative strength index and moving average indicator. Hari, Yulius and Dewi, Lily Puspa (2018)
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