The relative strength index (RSI) is most commonly used to indicate temporarily overbought or oversold conditions in a market. An intraday forex trading strategy can be devised to take advantage of indications from the RSI that a market is overextended and therefore likely to retrace.
The RSI is a widely used technical indicator and an oscillator that indicates a market is overbought when the RSI value is over 70 and indicates oversold conditions when RSI readings are under Some traders and analysts prefer to use the more extreme readings of 80 and
A weakness of the RSI is that sudden, sharp price movements can cause it to spike repeatedly up or down, and, thus, it is prone to giving false signals. However, if those spikes or falls show a trading confirmation when compared with other signals, it could signal an entry or exit point.
It is not uncommon for the price to continue to extend well beyond the point where the RSI first indicates the market as being overbought or oversold. For this reason, a trading strategy using the RSI works best when supplemented with other technical indicators to avoid entering a trade too early.
Here are some steps to implementing an intraday forex trading strategy that employs the RSI and at least one additional confirming indicator:
It is considered good practice to look at initiating a trade looking to profit from a retracement if one of these additional conditions are met:
If the above conditions are met, then consider initiating the trade with a stop-loss order just beyond the recent low or high price, depending on whether the trade is a buy trade or sell trade, respectively. The initial profit target can be the nearest identified support/resistance level.
To calculate the RSI, you must first determine a time frame: one week, two weeks, and so on. From there, you have to sum the average gains and divide the value by the sum of the average losses. This value is the RSI.
There is not specifically a "good" RSI index. RSI values are indicators that help traders make decisions depending on their goals. RSI values below 30 usually indicate buy signals whereas values above 70 generate sell signals.
Different indicators provide different insights. RSI provides insight into overbought or oversold assets. It is not very helpful in identifying trends. The moving average convergence divergence (MACD) indicator is better suited for that.
The RSI helps traders understand when a market is overbought or oversold so that they can expect either momentum or a pullback in prices.
If the RSI, along with other indicators, is set up and read correctly, it can help technical traders determine their trading strategies, such as entry and exit points, buying or holding, or shorting positions. RSI can be used in a variety of markets, including stocks and forex.
The “Relative Strength Index” or “RSI” indicator is a popular member of the “Oscillator” family of technical indicators. J. Welles Wilder Jr. created the RSI to measure the relative changes that occur between higher and lower closing prices. Traders use the index to determine overbought and oversold conditions, valuable information when setting entry and exit levels in the forex market.
Mr Wilder was born in America in Norris, Tennessee, in and only recently passed away in He was a mechanical engineer and real estate developer by trade, but he is revered for his many contributions to the field of Technical Analysis. The RSI is, perhaps, his most popular indicator, but he also fathered the Average True Range, the Average Directional Index, and the Parabolic SAR. Forbes Magazine acknowledged him in as “the premier technical trader publishing his work today”. His advice: “If you can’t deal with emotion, get out of trading.”
To heed his advice, you need to be disciplined and stick to a strategy based on indicators like the RSI. The RSI is classified as an oscillator since the resulting curve fluctuates between values of zero and The indicator typically appears at the bottom of a chart and has lines drawn at both the “30” and “70” values denoted on the right border as warning signals. Values exceeding “85” are interpreted as a strong overbought condition, or “selling” signal, and if the curve dips below “15”, a strong oversold condition, or “buying” signal, is generated.
As with other oscillators, the RSI indicator attempts to measure how quickly and by how much the pricing movements of your chosen asset are changing in the market. The thinking is that investors will typically overshoot the mark when prices rise or fall, thereby presenting an opportunity to benefit from the psychology of other investors. The RSI posits that the way to detect this situation is to calculate the ratio of higher closes to lower closes. Coupled with another indicator and recognisable patterns, the Relative Strength Index can be a powerful tool.
The RSI indicator is composed of a single fluctuating curve. Traders will occasionally add an exponential moving average, as above in red, to enhance the value of the trading signals. In the example above, the “Blue” line is the RSI, while the “Red” line represents an “EMA” for the same period variable of “8”. The RSI is viewed as a “leading” indicator in that its signals foretell that a change in trend is imminent. The weakness in the indicator is that timing is not necessarily a product of the RSI, the reason for attaching a “lagging” moving average to confirm the RSI signal.
The RSI indicator is common on MetaTrader4 trading software and is often a standard issue for even the best proprietary trading platforms. The calculation formula sequence involves these three straightforward steps:
Wilder introduced the Relative Strength Index indicator in in his book, New Concepts of in Technical Trading Systems, well before the advent of personal computers. Did Wilder prepare his calculations manually, or did he rent computer time? The answer does not matter in our time because software programs in today’s modern trading platforms perform the necessary computational work and produce an RSI indicator, as depicted in the chart shown above.
Like many other veteran traders of his time, Wilder had scars from trying to anticipate changes in the price direction of a particular asset. He wanted something that would give him an edge as to when a pricing reversal was imminent. He devised a formula using previous pricing data to predict when a market was oversold or overbought, not necessarily the bottom or top, but an indication that, within a short period, the peak or valley might appear.
The popularity of the RSI was immediate. Wilder also spoke to many subtle nuances in how the movements in the RSI could be interpreted in addition to the fabled oversold and overbought situations. Other analysts have also shared their insights over time on mid-line insights and divergences, together with the basic tenets of the indicator. As always, however, the RSI is not perfect. The traditional period setting of “14” can be modified, yielding a more sensitive gauge, accompanied by false-positive signals, as well.
Wise traders understand that one indicator cannot be the “Holy Grail”. However, one can provide insights. A complementary indicator can provide further confirmation. When combined with candlesticks, pattern recognition, and levels of support and resistance, a powerful RSI strategy can be developed, producing better than average results over time. The main point is to practice trade and get familiar with this indicator and its nuances. Veteran traders always swear by their practice sessions as a way to “deal with emotion”, per Mr Wilder.
Wilder had his own opinions about the signals that his innovative indicator produced. He was not content to look at only instances where the RSI crossovers occurred, which would signal a possible oversold or overbought condition. He and others also viewed the 50% line as a place where intuitive insights could be gleaned. Lastly, the issue of divergence is another focal point in these studies, those areas where the RSI is acting contrary to the current price action. Lastly, Wilder believed his RSI indicator could also telegraph signals independently of pricing behaviour. Other analysts have expanded on this concept as RSI bullish/bearish trends.
Let’s look at the conclusions that others have made once they felt that the RSI indicator explained where pricing behaviour was destined to go in the short term:
It does not matter what classification you wish to put on an observance of the RSI reacting to real-time price behaviour. The primary takeaway is that it takes experience, typically gained through a disciplined practice regimen, to learn the nuances of this powerful tool. In the following sections, we will suggest how to build a strategy around the RSI indicator and then show an example.
The following trading system is for educational purposes only. Technical analysis takes previous pricing behaviour and attempts to forecast future prices, but, as we have all heard before, past results are no guarantee of future performance. With that disclaimer in mind, the “Green” circles on the above chart illustrate optimal entry and exit points that can be discerned by using RSI analysis in combination with the added EMA in red.
For this “30 Minute” chart example, the RSI was set with a period setting of “8”. It is presented on the bottom portion of the above chart for the “GBP/USD” currency pair. The “Blue” line is the RSI, while the “Red” line, added as an additional option on the MetaTrader 4 platform, represents an exponential moving average for eight periods.
The critical reference points are high points and low points, especially when respective values cross 15 or The “RSI Rollercoaster” tends to work better for longer timeframes, i.e., daily, but shorter periods can be accommodated, as shown here. The RSI attempts to convey pricing momentum, but sideways action in the market can confuse.
A simple trading system would then be:
Steps “2” and “3” represent prudent risk and money management principles that should be employed. This simple trading system would have yielded three profitable trades of 80, , and “pips”, but remember that the past is no guarantee for the future.
As with any technical indicator, an RSI chart will never be % correct. False signals can occur, but the positive signals are consistent enough to give a forex trader an edge. Skill in interpreting and understanding RSI signals must be developed over time and complementing the RSI tool with another indicator is always recommended for further confirmation of potential trend changes.
To perfect a new trading strategy such as the RSI strategy we outlined in this article you need to practice it. Reading the charts and timing your entry and exit points correctly are skills that need to be mastered in order to maximise your profits. This is where a forex demo account comes in: It allows you to practice your new strategy without risking any of your hard-won capital. Below we have picked out some of our favourite forex demo accounts for you to practice in.
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Occasionally, the forex market will give you great opportunities to capitalise on a signal from an RSI indicator. If it were that easy, forex trading casualty rates would never be as high as they are. When looking for a trading setup, you will want to make use of two or three of your favourite indicators that work in tandem to reward your effort.
We have chosen the “EUR/USD” pair in this example, using a “4-Hour” period. Our indicators include the RSI, the Average True Range (ATR), and Bollinger Bands (BB). In the first Green circle, the bands of the BB have expanded, signalling an imminent change from ranging behaviour. The ATR in the Green oval is suggesting the same thing, but the RSI has entered oversold territory.
The Wilder proposition that the 50% line can act like resistance is coming into play. The mid-line of the bands is also acting as resistance. It is time to sell the Euro short versus the USD. The time to close is in the second Green circle to the right, where the RSI has broken the “70” line and then re-emerged above it. If you took your gain at this point, you would have realised pips.
The Relative Strength Index (RSI) is a powerful tool that has proven its worth time and again, but to develop an effective trading strategy, it is recommended that one to two other indicators be incorporated within your system. Bollinger Bands and the ATR were chosen here for their visual simplicity. A percentage of the ATR helps establish stop-loss parameters, too. Practice with what feels comfortable, and then develop your own personal RSI trading strategy. Do not expect perfection, but a consistent edge is a formula for success.
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