The Role of RSI Indicator Settings in Modern Trading Algorithms

Modern trading algorithms are powerful computer programs developed to outperform markets. Many of them are built upon traditional indicators like RSI and automatically make trading decisions according to pre-programmed conditions. The RSI indicator is so popular that many trading robots are trying to incorporate it into the trading decision-making process. While traders often need to adjust the parameters manually, modern advanced algorithms often come with dynamic setting adjustment features. Let’s explain what RSI-based algorithms are and explore the role of proper settings when developing RSI trading robots. 

What is the RSI indicator - A quick refresher 

RSI indicator, just like all other technical indicators, is a mathematical formula that prices and displays important insights. It is calculated as: 

Average Gain / Average Loss over N periods, transformed to 0-100 scale. 

The indicator is especially popular for detecting overbought and oversold conditions. The default setting is 14, meaning the indicator is calculated for the last 14 candles/bars. The indicator’s origins start decades ago when J. Welles Wilder developed the indicator, and the 14-day period has been its default setting ever since. It is also widespread, and when you apply RSI to a chart, the default setting is set to 14 in almost all advanced trading platforms.

Overbought, oversold, and divergence 

When the RSI indicator is above 70, it is believed that markets are in an overbought condition, while when it is below 30, markets are oversold. Divergence is when the RSI shows lower lows while the market is printing higher highs. Divergence is used to detect potential reversals early and anticipate major price swings. Bullish divergence is when price prints lower lows and RSI higher lows, and bearish divergence is when price tends to create higher highs, but RSI creates lower highs. Divergence signals potential weakening trends. 

Importance of RSI settings

The RSI indicator, just like most indicators, is lagging, and changing settings has a crucial impact on trading signals. Shorter periods like 7, 9, and 10 make RSI more sensitive to price changes, and it generates more signals, including false signals. Longer periods beyond 10 make RSI smoother and less reactive, but it generates fewer signals, and the focus is on broader trends. 

RSI settings in algorithmic trading

In the context of algorithm trading systems, RSI settings have a tremendous impact on performance. Shorter periods (N) suit scalping and high-frequency stratification to capture quick reversals. Longer N periods suit swing trading and trend-following algorithms to get confirmations and avoid market noise in the process. When selecting the best RSI settings, algorithmic traders should also ensure that to match the algorithm’s holding period and market context. For example, in strong trends, RSI will issue many false signals in the opposite direction, and traders should add additional filters to ensure the algorithm trades in the direction of the main trend. 

Oversold and overbought thresholds

While the default thresholds are 30 for oversold and overbought above 70, these numbers are not sacred, and algorithmic traders can adjust them dynamically if the strategy requires. Tighter thresholds like 80/20 in strong trending markets enable your Expert Advisors to avoid premature exits. Looser thresholds like 60/40, on the other hand, are perfect in ranging markets to capture mean-reversion trading opportunities. Since thresholds directly define entry and exit conditions, it is mandatory to test different numbers extensively on both historical data and a demo account for live insights. Optimizing these numbers is critical for risk management to avoid entries in false extremes and enhance signal quality. Many algorithmic traders also employ dynamic thresholds that can be based on ATR or other volatility measures, which is an advanced concept. Traders need extensive knowledge in programming to implement these changes, or they will have to hire a trained professional to develop the EA for them. 

To ensure the maximum effectiveness of RSI settings, traders often add additional confirmations such as moving averages. This effectively reduces whipsaws and provides an additional layer of confirmation against market noise.