Trading with the Relative Strength Index
The RSI is a useful technical indicator that can help you to pinpoint overbought/oversold conditions in foreign exchange markets. It was originally developed by famous technical analyst J. Welles Wilder for use in commodity futures markets but can be applied to any actively traded financial instrument. An RSI under 30 indicates undersold conditions whilst an RSI over 70 indicates overbought conditions, and these two values are represented by horizontal lines on the RSI graph to make it easy for you to spot when they are breached.
If you want to know how the relative strength indicator is able to highlight the existence of overbought/oversold conditions, you will need to know how the index is calculated.Relative Strength Index Calculation
The RSI indicator belongs to a class of technical indicators known as momentum oscillators, which are designed to help traders follow changes in the momentum of price. To see how RSI levels are able to reflect changes in momentum, we need to look at the Relative Strength Index formula, which is divided into 2 parts:
- Calculating the Relative Strength (RS) – First of all, we need to calculate the relative strength of a currency pair. The formula for this part of the calculation is most simply expressed as the average of the upward prices movements in a given time divided by the average of the downward movements in the same time. As an example, if you set your RSI period at 14 and you apply the indicator to a 5-minute chart, the indicator will take the average of the price gains for each bull bar in the last 70 minutes (70 minutes = 14 × 5-minute bars) and then divide that average by the average of the price drops for each bear bar in the last 70 minutes.
- Calculating the Relative Strength Index – To arrive at the RSI index value, the indicator uses the formula, "RSI = 100 - 100 / (1 + RS)". This will give you the RSI values at any given moment in time for the currency pairs you are trading.
Of course, very few traders read the instructions on how to calculate Relative Strength Index then follow the instructions and perform their own calculations manually. The easiest way to actually use the RSI indicator as part of your trading strategy is to add the indicator to charts in your trading platform and let it calculate values for you automatically. Trading platforms such as MT4, MT5 and TradeStation all come with a full suite of technical analysis indicators that can be added to your charts in a matter of seconds. In the next section, we will look at how you can incorporate the RSI into your daily trading plan.
RSI Trading Strategy Ideas for Currency Traders
By adding the RSI indicator to your charts, you can ensure that you are aware when the currency pairs you trade move into overbought or oversold areas. As with any technical analysis indicator, it is not a good idea to blindly follow the RSI: you need to consider market volatility and sentiment at the same time. With that said, let us now look at a simple RSI FX trading strategy that any trader will easily be able to understand.
Trading RSI Divergences with Price Action
The creator of the index himself suggested that divergences between the RSI and price action could signal possible reversal points, which traders can use to enter new trades. If, for example, support or resistance levels are holding as far as the price action on your charts is concerned but RSI support and resistance levels are being broken, this could be a good time to enter a trade in the direction suggested by your RSI indicator. Another way to spot divergences is by making a note of common chart patterns/movements that occur in your chart but are contradicted by the RSI graph. For example, the price action makes a lower low, suggesting that price is still moving south but the RSI graph makes a higher low, suggesting that the downward momentum is fading and perhaps a reversal may be imminent.
If you do not want to rely on your own ability to spot such divergences, you can use the RSI divergence indicator for MT4, which highlights the points where they occur.
2-Period RSI Trading Strategy
If you add the Relative Strength Index indicator to your charts and leave the RSI parameters at their default values, you will be looking at a graph that uses a 14-period average to determine RSI values at any given time. This is the most popular setting for traders who wish to use the index to spot major turning points in their charts but if you would like to use the index to highlight short-term swings, you can set the RSI period to 2. If you do this, the index value that you see will be reflecting the average of the last 2 periods in your chart rather than the last 14. When the index drops below 10, you can interpret this as a buy signal and when it rises above 90, as a sell signal.
RSI Range Shift
You can also use the index to gauge market sentiment, taking your RSI indicator buy and sell signals from shifts in the range of the index. For this method, RSI values from 40-80 are considered to be in a bullish range and from 20-60 are considered to be in a bearish range.
There are many other interesting strategies you may like to investigate, such as the use of the RSI crossover indicator, which involves adding an RSI moving average to the mix and taking note when the index line crosses over the moving average.
Main Takeaways for Active Currency Traders
Whether you use an RSI line graph to spot possible short and long-term swings in price action or to take advantage of RSI bullish divergence and bearish divergence points, you need to bear in mind that, in common with all technical indicators, an RSI forex indicator will serve you best when used in conjunction with conventional price action analysis.
