RSI is one of the most popular oscillator indicators in forex trading. Here's a complete guide on how to use it in your trading strategy.
Getting profit in forex trading is not easy, that is why traders need to have a proper trading strategy before entering the currency market. There are lots of trading tools that traders can use in order to maximize the accuracy of their market analysis and thus, improve their trade.
One of the most popular oscillator indicators to use in forex trading is the Relative Strength Index (RSI). Since it is pretty famous among traders, you may have likely read some general articles or have at least heard about it. In this article, we're going to get deeper into how to trade with the RSI indicator.
Defining RSI Indicator
The Relative Strength Index (RSI) is a technical indicator that measures the magnitude of price changes in a certain period to analyze whether the conditions of the price in a certain market have reached oversold or overbought. The concept was first introduced by an American technical analyst J. Welles Wilder Jr. in his seminal book called "New Concepts in Technical Trading Systems" back in 1978. Since then, the indicator became popular and widely used in trading with various types of assets.
Essentially, the indicator is able to refine the appearance of the momentum indicator and create a fixed range limit, so that its appearance is consistent. RSI is a part of the oscillator indicator category, which typically shows a line graph that moves between two extremes. The purpose of this indicator is to show the primary trend of an asset which further determines if the asset is overbought and oversold in the market. It is in fact, a piece of valuable information to set entry and exit levels in the forex market. Apart from that, it can show signs of emerging trading opportunities.
The RSI Formula
Here's how to calculate the RSI indicator:
RSI = 100 – [100 / (1 + RS)]
- RS = Relative Strength = Average U/Average D
- Average U = average of all up moves in the last N price bars
- Average D = average of all down moves in the last N price bars
It's not necessary for you to do these calculations while you're trading because most trading platforms that offer RSI normally do all the math for you. Using RSI in a trading platform is very easy: you just have to simply choose RSI from the list of indicators available on the platform, enter the desired parameters, choose a time frame, and you're good to go.
How to Read RSI Indicator
As an oscillator indicator, the resulting curve of RSI fluctuates between 0 and 100. The indicator usually has lines drawn at 30 and 70 as oversold and overbought limits respectively.
The values that break upon those key levels are worthy of attention, especially when it crosses 15 or 85. RSI values that move higher than 70 are considered as a strong overbought condition and indicates a selling signal, whereas if the value falls below 30, it is a strong oversold position and indicates a buying signal.
This indicator works best at ranging markets and at longer time frames. However, keep in mind that the key overbought/oversold is not always 70 and 30, but it can also be 80 and 20, depending on the characteristic of the currency pair that you're trying to analyze.
As with any technical indicator, there's no guarantee that an RSI chart will always be accurate. False signals can occur, so it's always recommended to combine the RSI tool with other indicators in order to further confirm the potential trend changes. Alternatively, you can also use the RSI indicator in various trading strategies.
How to Use RSI Indicator in Strategies
If you're using MetaTrader, in order to display the RSI chart, you just simply have to click Insert >>> Indicators >>> Oscillators >>> Relative Strength Index. The default setting period is 14-day. Afterward, we're going to explore the various trade setups using the indicator.
Simple Trading System
Once you can see the RSI chart on the screen, you should just focus on the key points of reference, which are the overbought and oversold limits. A simple trading system following this analysis would be like this:
- Determine your entry point when the RSI value dips below 30 or rises above 70.
- Execute a buy order if the value is below 30 and a sell order if the value is above 70.
- Place a stop-loss order a few pips below/above your entry point.
- Determine your exit point when the value hits the opposite limit.
This strategy uses extreme values as a basis for assessing overbought and oversold conditions. So when you use a value above 80, it means taking advantage of an overbought condition and vice versa.
Unfortunately, there's a downside to this method. If you use the default setting (14 RSI), it's quite rare for the price in the forex market to reach these extreme points. Therefore, it gets harder for traders to find trading opportunities based on that sign only. The solution is to use periods other than the default 14. You can use lower periods like 7 RSI.
RSI (7), 20/80
RSI (14), 30/70
In the two pictures above, we can see how different parameter settings can heavily affect the value of the RSI indicator. In this case, some traders consider the RSI (7) setting with a reference value of 20/80 as more accurate than the default RSI (14) with a reference value of 30/70.
But the truth is that it doesn't always work like that for everyone, so you are free to try different settings and combinations in order to find the most appropriate parameters for your trading system.
Combining RSI and Trend Lines
The RSI indicator is also often used in conjunction with trend lines. Putting the two tools in one screen will show whether the support and resistance trend lines on the chart coincide with RSI signals that indicate a breakout from the trend lines.
You can see in the illustration above that the red resistance line on the chart is in confluence with the downtrend line drawn on the RSI chart. The downtrend seem to keep going strong until the RSI broke it, followed by an upside reversal. Similarly, we can see that the green trend line on the price chart is also in line with the uptrend line drawn on the RSI, reflecting a similar breakout that happens later.
Divergence Trading with RSI
Divergence describes a condition in which the asset's price moves in the opposite direction from the indicator. There are two types of RSI divergence, namely:
1. Bearish Divergence
A bearish divergence happens when at a certain point the price moves up while the indicator moves down so that it seems as if the two are going in separate directions. The price basically shows an upward trend while simultaneously print new Higher Highs (HH) and new Higher Lows (HL), but remains unconfirmed by the oscillator. This situation basically illustrates a weak uptrend and signals a possible downtrend. It shows a good sign to open a short position.
See Also: How to Trade Using Divergence Strategy
2. Bullish Divergence
A bullish divergence occurs when the price moves down while the indicator moves up so that it seems as if the two lines are going to meet at a certain point. The price basically shows a downtrend with new Lower Lows (LL) and Lower Highs (LH), but the oscillator hits Higher Lows (HL) instead. This shows that the downtrend is weak. In this case, the best trading strategy would be to prepare a long position, as there is a signal for a possible uptrend.
The Bottom Line
RSI is a great technical indicator to use in forex trading as it can offer functionalities such as determining whether the market is overbought/oversold, signaling trend reversals, and determining entry and exit points. Skill in interpreting and understanding RSI signals can be developed over time, so it's necessary to learn as well as try it in different market conditions.
One thing to keep in mind is that just like any other technical indicators, RSI is not 100% accurate on its own. This is why your analysis must not rely only on the RSI indicator. It's best to combine RSI with other trading tools like Moving Average, Bollinger Bands, price action analysis, etc. so you can get a stronger confirmation and more accurate trading signals.