- April 19, 2022
- Posted by: CoachShane
- Categories: Trading Article, Trading Indicators
You don’t need complexity to have a trading strategy that can work and the 20 SMA with RSI is anything but complex.
We can use the trend following capability of the simple moving average for not only trend, but for an average price of X periods.
The relative strength index will show us the momentum of price over a set period.
Combining these two technical indicators can make up the backbone of a trading strategy.
20 SMA And RSI Chart Setup
Unlike a multiple moving average crossover strategy, we are going to use one simple moving average set to 20 periods.
The SMA will give us an overall trend direction and when you use a moving average, you will get price breaking and reclaiming the average. If we blindly used price crossing the average as a trend indicator, we’d get whipsawed during the “splash” around the average.
Including swing levels into the strategy will ensure that we are also using price structure (higher highs and lows for uptrend) as a confirmation of trend direction.
The RSI (relative strength index) will be used to gauge momentum and will include the 50 line. The RSI will show us that price is retracing against the trend and setting up a potential trade. We will need to see the RSI cross the 50 level to the downside when trading an uptrend, and cross to the upside when looking for short trades.
What Is The 20 SMA And RSI Setup?
The strategy is using the natural pullbacks during trending markets and gauging momentum as price attempts to reverse back in the direction of the trend.
On the left side of the chart, A is showing an uptrend as price is above the 20 SMA and above a prior swing high.
Price pulls back at B to the moving average and while price does break the average, it does not take out a prior swing low at C. The uptrend is still intact.
During the pullback, we have the RSI at D moving below the 50 level of the indicator. This is showing some weakness in the instrument. We then get a hook up in the RSI at E which signals the setup is complete.
There are a few methods to enter the trade once the setup is confirmed.
Once the RSI hooks back up, a trader can buy stop the high of the candle that turned the indicator to the upside. Changing the direction of the indicator will show momentum has, at least for the time, stepped back into the instrument.
Another trade entry can be a break of the diagonal green trend line. This will take into account the momentum shift as shown by the RSI and a change in the rhythm of the instrument to the downside.
A close back above the 20 SMA could also be used as the trend entry upon close or using a buy stop entry above the high for a long.
Protective Stop Loss
No trade should occur without an understanding of where you will get out if price turns against you.
Placing the stop under the most recent swing low (for a long) is a standard placement. Also consider using a multiple of the average true range to place your stop. Some traders will even choose to use the low of the entry candle for their stop.
The benefit of a closer stop loss is using a higher position size. Traders that use a distant stop loss location will give up some position size in exchange for a bit of play in price action. A trader has to know what they can tolerate. Some traders won’t tolerate much price action against them and will use the closer stop. Others want to be proven wrong by a violation of price structure.
While 3:1 reward to risk ratios sound great, they are not always easy to achieve. The only thing we can know for certain is our entry price and barring slippage, our stop loss price. The profit is the unknown.
Some traders will use a 1.5:1 RR ratio knowing they will get many more 1.5R targets than they ever will 3R targets. The 20 SMA could be used as a trailing stop or we could even use the 1.272 Fib extension target.
In this example, price target of the 1.272 Fib extension and a 1R profit targets have been hit. The 20 SMA trailing stop is still underway.
You can mix and match profit targets by scaling out at 1R and then using the trailing stop feature/extension target.
There is no best exit for profit and will depend on each trader.
Short Trade Example
This is a daily currency chart and on the left, we have a legitimate long setup that rallied for 167 pips before stalling at the moving average.
Price breaks below the moving average and takes out a low confirming the new down trend in price.
Price rallies on the right side up to the moving average, the RSI hooks and a trade entry using a sell stop occurs. Price eventually falls 202 pips to lows.
The price range is confirmed using the moving average and the obvious tight consolidation that is taking place between the extreme high and low on the left side of the chart.
Looking at a recent chart of ETHUSD gives us a less clean looking chart which is more indicative of the conditions you will face as a trader.
The vertical black arrows are showing short trade examples due to price not breaking the swing high on the left of the chart.
Eventually, we see a consolidation chart pattern as price gets trapped between the swing high and low extremes.
The right side of the chart shows a swing high taken out and a short term uptrend in play. As of this chart, a long position would be the setup to look for.
A trader may have gotten long around the first consolidation on the right side. On the second consolidation, a trader would be long depending on how close the buy stop was set.
If an order is set and not triggered, we may find ourselves in a consolidation. When that occurs, you will only want to look for trades when the extreme of the consolidation is breached and you have RSI support – it’s hooked in your direction.
Remember, we have several entry methods to choose from and one may be better than another in certain market conditions. There are some nuances to trading that can only come from actual experience. Everything from candle size and type to momentum in the pullback, there are some variables that will alter your approach. For the most part, those should still be in your trading plan.
Using a one hour chart will give us more trading opportunities but not all will be quality.
In the middle, we get a confirmed uptrend and a setup. The actual setup candle is very small bodied, closed right in the middle of it’s range, and may not be one to consider. When these small candles occur, we may also see the start of even small candles leading us into a consolidation. In this case, traders looking to get long would use the highest high of that range.
You can see the gap up and chasing trades is never a good idea.
We then get a pullback to the SMA and RSI dipped below 50. Again, we get a small candle very similar to the one we skipped earlier.
Using the trendline break entry technique gets us into a position that runs up almost 4%.
Traders will use the 20 SMA for a pullback location and, along with support/resistance levels, trend determination. We will need to see a swing level break to confirm trend. Until that happens, we will take trades in the direction of the current trend regardless of price breaking the moving average.
The RSI will show us weakness against the trend and with it’s hook back into the direction of the trend, a confirmation of an entry signal. Remember, during the pullback, the RSI must break the 50 level.
There are several ways, conservative and aggressive, to enter these trades. I would prefer the trend line break entry especially if we are in a complex correction.
Setting stops and targets will be unique to every trader. We all have difference tolerances with risk and profits so you need to find what works for you and your understanding of trading.
Final Words – 20 SMA/RSI
A simple strategy that uses the natural evolution of price. A trader can quickly scan many instruments to see if price is close to the moving average and RSI on the opposite side of the 50 level.
Adding more indicators will add complexity however having rules surrounding consolidations and candle types can add to the performance.
If interested in this strategy, I highly suggest going through many charts on your preferred time frame.
Thanks for reading and any comments, please put them below.