The Relative Strength Index (RSI) is a useful technical indicator commonly used by traders to gain an insight into current price momentum. It calculates recent gains and losses in price against momentum and displays a line graph that oscillates between a scale of 0-100.
As the graph reaches the higher end of the scale it can be interpreted that prices are currently overbought and as it reaches the lower scale, it can be treated as an oversold signal.
This article discusses the pro's and con's of Forex trading using the Relative Strength Index.
In This Article:
- Using The Relative Strength Index
- Modify Settings During Strong Trends
- Importance Of Overbought And Oversold
- Understanding The Range
- Summary
Using The Relative Strength Index
The Relative Strength Index is technical tool that is provided to technical traders by online brokers. It is a momentum oscillator that usually sits beneath a technical price chart so that it can easily be read and easily cross referenced with current price action, as shown below:
On the above EUR/USD 8hr technical chart it can be seen how the Relative Strength Index oscillates between overbought and oversold.
When the bullish trend was at it's peak, the Relative Strength Indicator was just touching 70. This can be interpreted as being overbought, at this point, traders may anticipate a reversal and exit long positions. This is in fact what happened and a strong downward movement in price occurred that netted 350pips.
The chart shows again that as price reached it's lowest point, the Relative Strength Index was displaying an oversold signal by moving below a reading of 30. Traders will view the oversold reading as a possible signal of a reversal and exit their short positions. Following the signal there was sharp reversal upwards that netted another 350pips.
The above chart is a clear example of how the RSI indicator can be used to understand momentum and enter trades early in anticipation of a reversal. It is also useful to gain an insight into when is a good time to exit a trade and take potential gains prior to a reversal materialising.
Modify Settings During Strong Trends
Prior to using the Relative Strength Index to make trading decisions, it is important to identify the current trend as the indicator settings may require adjusting. The settings are usually pre-set to indicate and overbought signal at 70 and oversold at 30.
During a strong trend, lets assume a down trend, it may be more probable that overbought occurs at a reading of 50. To determine this it would be wise to plot a line on the RSI across the peaks of the indicator during the trend in question. Lets look at an example:
On the above EUR/USD 1hr chart a trend line has been plotted showing a strong downward move. The Relative Strength Indicator is shown below and also plotted is a trend line across the previous peaks that have occurred during the trend. As the peaks have not exceeded a reading of 50, it would be prudent to adjust the settings of the indicator to reflect this.
As the indicator approaches the adjusted overbought line, preparation for a short position should be made to trade in-line with the longer term down trend.
» For more on trend line see our our guide how to draw a trendline.
Importance Of Overbought And Oversold
The Relative Strength Index is a momentum oscillator that provides overbought and oversold readings to its users.
Oversold
An oversold reading generally occurs when the indicator is showing a reading of 30 or less, unless modified. This may be treated by technical traders as a bullish trading signal as prices are trading beneath the currency pairs real value. At this point, a price reversal may be anticipated and traders will look to exit any short positions that are held in favour of long positions.
Alternatively, if the reading occurs during a strong downtrend, they may exit the position and wait until an overbought signal is provided to re-enter in the direction of the longer term down-trend as this form of trading is considered to provide higher probability trading.
» Read our article trend trading for a proven strategy for more on the benefits of trend trading.
Overbought
An overbought signal is provided when the Relative Strength Index displays a reading of 70 or over, unless modified by the user. This can be interpreted as a bearish signal that a trend reversal in a downward direction is likely. Traders will exit their long positions and either enter short positions, or wait for the next oversold signal to enter a long position.
Understanding The Range
It is important to remember that the Relative Strength Index is a momentum indicator and should be read as such. Understanding the range in which the indicator moves, and not simply waiting for overbought and oversold signals, can provide extremely useful information.
We have discussed previously that a reading of 70 or above would be an overbought signal and conversely a reading of 30 or below would be an oversold reading. Lets assume that prices have been very bullish with 70 being hit regularly and never getting near 30 and are considering entering a long position in line with the longer term trend.
However, recently the highs of the RSI indicator are lower and the low, while still not reaching oversold, are certainly getting lower. This would be an indicator that although prices are still bullish, the trend may be weakening. It would be prudent to undertake some multi time-frame analysis and look at lower time frames to see if a downturn is occurring. If there is downward movement on lower time-frames, it would be wise to re-consider taking a longer position and wait to see what transpires.
» For more on this see our guide using multi time-frame analysis.
Summary
Trading using the Relative Strength Index (RSI) can be a very powerful technical technique to identifying early price reversals.. As with any form of technical trading, the long term trend should be acknowledged before relying entirely on the RSI for guidance. A strong trend can bias the RSI readings and it may be worthwhile to adjust the parameters to identify adjusted entry points and avoid trading against the trend.
