Binary options type of trading gives best results on strong trends and one-way price action when traders keep buying call or put options depending on the trend’s direction. However, asset prices usually move like waves, bouncing off resistance or support levels, and reversing the action several times per day. Technical analysts noticed that one of the most effective parameters describing the market’s sentiment is momentum, while certain market conditions are called oversold or overbought. In the late 1970s, a new concept was developed by J. Welles Wilder Jr. - Relative Strength Index - a momentum indicator or oscillator, measuring the significance of recent rate evaluation compared to the previous period. That method gave birth to RSI Binary Options Strategy, which became one of the most popular trading systems.
What is RSI Binary Options Strategy?
RSI Binary Options Strategy is based on Relative Strength Index oscillator and several combinations of other technical indicators. That’s a multi-purpose trading system, working effectively with a wide variety of asset classes in sideways ranges, as well as in strong trends. The RSI oscillator acts as the main technical tool for the analysis of current market conditions, showing when the underlying asset is oversold or overbought, suggesting several reversal patterns. At the same time, the oscillator has two conditions. It’s fair to say that the stock or other security is in an uptrend when RSI value is above the level of 50, and it’s in the downtrend when RSI is below 50. Relative Strength Index has also an ability to show so-called divergences - strong reversal signals for binary options.
How to use RSI Options Strategy?
RSI is represented as a traditional oscillator with a separate window under the price chart. Its ranges from 0 to 100 and the level of 50 usually divides the indicator’s value into two parts. Additional lines come at the level of 70 (overbought) and 30 (oversold), showing strong price movements. The screenshot below shows how the RSi indicator binary options looks like.
RSI settings for Day Trading
Thanks to a simple and reliable mathematical formula, which calculates relation of recent price gain to the latest loss in a given period, binary options traders can adjust the key parameter for the RSI oscillator - the period of calculation. The default period is 14 bars or candlesticks. For example, if the analysis is made on a daily timeframe, then RSI calculates the value in last 14 days. For the hourly chart, RSI with the same period will take into account 14 hours.
Some technical analysts use Fibonacci numbers for the period from 13 bars for fast aggressive trading approach on short-term charts and 21 bars for conservative trading method on longer timeframes like binary options daily strategy. Choosing the most efficient period depends on individual trading strategy, the timeframe and expirations time of binary options.
Another important parameter to modify is the value of oversold/overbought levels. The default and the most widely-used relation is 30/70, while some of the binary options traders prefer a combination of 20/80 to smooth the unnecessary market noise and avoid too many false signals.
The flexible nature of the indicator and multi-purpose application allowed binary options traders to notice several patterns on the RSI indicator window, and develop different trading signals pointing to a high likelihood of current trend’s reversal. There are four main patterns for different applications and scenarios.
When an asset is trading in a sideways consolidation range without clear direction, binary options traders take advantage of RSI indicators ability to show overbought and oversold levels. Once the oscillator touched the level of 30 or 70, a trading signal occurs and the trend changes the direction. Therefore, traders should consider buying CALL options on a test of the oversold level and PUT options when RSI indicator reached the overbought zone.
Here is an example of RSI indicator range:
Overbought and Oversold Levels
During a strong trend, overbought and oversold levels can be shifted. This technique is used to measure the depth of possible retracements and corrections. For instance, when RSI bounces off the oversold zone and inches up to the level of 50, that threshold is considered as the overbought level, and new put options can be bought from there. For an uptrend, the condition is the same but mirrored. This pattern is also called a bounce by trend. An example below shows how the threshold of 50 acted as the overbought level.
Bearish or Bullish divergence
This signal occurs when the price action does not come in accordance with the RSI performance. For instance, the chart shows higher highs of the rate, while RSI oscillator draws lower highs. That contradiction is called a bearish divergence as it signals a potential reversal of the trend. Bullish divergence happens when the price of an asset charts lower lows but RSI prints higher lows. Bearish and bullish divergences are usually strong and reliable reversal signals.
Swing rejection pattern Example
This is also a reversal signal, and it has four stages of the action.
Best RSI settings for Swing Trading:
- RSI drops to oversold zone as the sequence of strong downtrend;
- RSI edges back above 30;
- RSI falls again without entering the oversold zone;
- RSI breaches the recent peak value.
Best Indicators Combination in RSI Binary Options
Relative Strength Index is considered as a fast oscillator with rather frequent change of sentiment. Therefore, the most effective performance can be achieved when using RSI with several additional technical tools like other oscillators or trend indicators. The aim is to cut unwished market noise and increase profits from trading systems, avoiding fake signals.
This is a combination of two oscillators in one window. Besides the RSI, here is used also usual Stochastic oscillator. The Stochastic RSI indicator has similar patterns as described above with the addition of another line. A crossover of two lines is considered as a confirmation trading signal as well. Both indicators parameters default on the chart below, however, traders can try to modify settings in order to get one of the oscillators slower than the other. That would reduce the frequency of trading signals but increase efficiency.
If you like this strategy, you might also be interested in this Triple Top and Triple Bottom
MACD vs RSI
One of the most popular combinations in technical analysis MACD and RSI. The main advantage of such an advanced RSI strategy is that it combines a slow trend indicator MACD with lagging performance and fast RSI leading oscillator. In this case, bearish or bullish divergence on the MACD indicator has to be confirmed or denied by fast RSI. Once a confirmation signal occurred, it’s time to enter the market, buying call or put options depending on the trend direction.
An example is shown in the chart below:
If you like this strategy, you might also be interested in this Reversal Trading
Limitations of RSI binary options
Some market conditions might force RSI indicator to stay in the overbought or oversold zone for quite a while. The lagging nature of the mathematical formula could cause false trading signals, which indicate short-term and limited corrections but not reversals of the current trend. Therefore, RSI needs additional technical tools to work in combinations, as well as in-depth analysis is required in terms of long-term trend definition and adjusting the settings according to the market sentiment.
Pros and cons
- Multi-purpose functionality;
- Works well in trendy markets and sideways ranges;
- Flexible settings for different timeframes;
- Reliable trading signals;
- Wide variety of patterns.
- Needs additional indicators;
- False signals.
Although the RSI Binary Options Strategy became very popular among traders nowadays, it has several disadvantages and limitations. Here is the list of RSI pros and cons.