How to Use the Relative Strength Index (RSI) in Forex Trading?

Introduction

The relative strength index (RSI) is frequently used to signal short-term overbought or oversold conditions in a market. An intraday forex trading strategy can be developed to capitalise on signals from the RSI indicating that a market is overextended and likely to retrace.

When using the RSI in trading, it's important to keep an eye on two key levels: 70 and 30. When the RSI exceeds 70, it suggests that the market is overbought, whereas a value below 30 suggests that the market is oversold. Traders frequently utilise these levels as initial triggers for trade considerations, often setting alerts accordingly.

When alerted, traders evaluate the feasibility of the potential trade. It's important to keep in mind that the RSI can sometimes give misleading signals, especially in volatile markets where it can stay above 70 or below 30 for long periods of time.

Therefore, although RSI indicators provide valuable insights, it is essential to conduct careful analysis and consider market conditions beyond these levels to make informed decisions. In this article we look at how one can use Relative Strength Index (RSI) in Forex trading.

Understanding the Relative Strength Index (RSI) in Forex Trading

The RSI is a commonly used technical indicator and oscillator that signals an overbought market when the RSI value exceeds 70 and indicates oversold conditions when RSI readings fall below 30. Some traders and analysts favour utilising the more extreme readings of 80 and 20.

One drawback of the RSI is its susceptibility to false signals due to sudden and drastic price fluctuations that can cause it to spike in either direction. However, if those spikes or falls indicate a trading confirmation when compared with other signals, it could suggest a potential entry or exit point.

Prices often continue to extend well beyond the point where the RSI initially indicates the market as being overbought or oversold. Therefore, it is advisable to complement a trading strategy that utilises the RSI with other technical indicators to prevent premature trade entry.

What goes into RSI?

The Relative Strength Index measures price changes over a specified number of periods, which you can input into the indicator.

When the RSI is set to 5 periods, it calculates the strength of the price movement of the candles in comparison to the previous 4 periods, giving a total of the last 5 periods. By utilising RSI with a period of 55, you can assess the strength or weakness of this candle in relation to the previous 54 periods. Using more periods will make the indicator appear to react slower to recent price changes.

Identifying trading setups using the RSI

Here are a few steps to effectively implement an intraday forex trading strategy that utilises the RSI and at least one other confirming indicator:

• Keep a close eye on the RSI to identify any signs of the market being overbought or oversold.
• Consider consulting additional momentum or trend indicators to validate any potential signs of a forthcoming retracement.
• It is advisable to consider initiating a trade with the intention of capitalising on a retracement if any of these additional conditions are met.

If the specified conditions are satisfied, it may be prudent to begin the trade by placing a stop-loss order slightly beyond the most recent low or high price, depending on whether it is a buy or sell trade. Consider using the nearest identified support/resistance level as the initial profit target.

How to calculate the RSI?

When calculating the RSI, it is important to establish a time frame, such as one week or two weeks. Afterwards, you need to calculate the total of the average gains and then divide that value by the sum of the average losses. This value represents the RSI.

How is RSI used in day trading?

When employing the RSI indicator for day trading, it's crucial to understand its role in identifying optimal trading opportunities within the same trading day. Day trading prioritizes quality over quantity, focusing on high-probability short-term trades rather than sheer volume.

In this regard, RSI strategies are invaluable because they enable traders to pinpoint favourable intraday setups in both ranging and trending markets. Day traders often adjust the RSI settings to shorter periods, such as 6 to 9, to generate more frequent overbought and oversold signals. Support and resistance zones strategically align these levels.

When the RSI falls below 30, range-bound markets trigger buying near support, and when the RSI exceeds 70, they trigger selling near resistance. In trending markets with even lower RSI settings (2 to 6), traders capitalise on pullbacks within the prevailing trend.

For instance, an RSI-driven retracement in an uptrend identifies buying opportunities, while an RSI-driven bounce in a downtrend identifies selling opportunities.

To enhance reliability, day traders often complement RSI signals with other technical indicators like moving averages, which validate trends and pinpoint potential retracement levels. This combined approach validates RSI signals through broader market dynamics, thereby optimising decision-making in fast-paced day trading environments.

Features of the RSI indicator

The RSI indicator, like other oscillators, appears in a separate window below the price chart. This technical instrument is composed of a single line and two default levels. The indicator's vertical axis range is set from 1 to 100, displaying the externality of the current price in relation to its past values.

Setting and adjusting RSI indicator

There are two ways to set up this indicator.

• The easiest way is to click the tab ‘List of Indicators’ located on the upper panel of the terminal and select ‘Oscillators’ – ‘Relative Strength Index’.
• Another option is to choose ‘Insert’ – ‘Indicators’ – ‘Oscillators’ – ‘Relative Strength Index’.

The instrument configuration window will open prior to setting the indicator on the chart. This window provides you with the ability to adjust the parameters of the indicators. The period is the main parameter that determines the number of price values used to plot the main indicator's line.

For shorter time periods, the movements on the indicator's chart will be more pronounced. The default value for this parameter is 14, which is generally considered to be the optimal setting in most situations.

Change style settings like line colour and thickness. Using another tab in the configuration window, you can adjust the parameters for the levels.

You can switch from 30 and 70 to 20 and 80. You can also incorporate additional levels if your strategy necessitates it.

Opening positions on RSI signals

The RSI oscillator generates a key signal that helps identify price ranges that are either overbought or oversold. While commonly employed as a filter in systems that rely on trend indicators, it could be worth considering trading solely based on RSI signals.

When the indicator's line surpasses the level 70 or falls below the level 30, it indicates that the market is either overbought or oversold. In such cases, it is advisable to wait for the next signal that confirms a potential trend reversal.

These are the rules for opening positions based on the RSI signals:

• If the indicator’s line crosses the level 70 from above, a (Sell) is opened.
• If the indicator’s line crosses the level 30 from below, a long position (Buy) is opened.

There are several conditions for closing a trade:

• Place a Stop Loss to local extremum and Take Profit to the value that is by 2-3 times greater.
• Exit on opposite indicator’s signal.

Nevertheless, relying solely on RSI signals for trading may not yield optimal results since it is intended to be used as a filter rather than the primary tool. Using a trend indicator or being mindful of price action signals can greatly enhance the efficiency of a technical trading strategy.

RSI trendlines

Contrary to what many people think, the RSI serves as a leading indicator. One way to gauge this quality is by utilising trendlines on the RSI chart and executing trades based on their break. When the RSI rises, you can create an upward trendline by connecting two or more lows and extending the line into the future.

It is important to note that when the RSI is decreasing, it is advisable to draw a downward trendline by connecting two or more highs and projecting the line into the future. Breaking an RSI trendline often signals a potential price reversal or continuation in the market.

For example, when the asset price surpasses a downward trendline, it indicates that the price is likely to move upward. This could either be a continuation of an upward trend or a reversal of a downward trend in the market.

Disadvantages of trading with RSI

Traders often find a flaw in the Relative Strength Index. RSI, naturally, seeks out price reversals. When traders purchase a market that has already been declining, such as when the RSI crosses above 30 or is considered 'over-sold,' they are essentially making a counter-trend trade.

If a trader sells when the RSI crosses below 70, it indicates that the market has experienced significant upward movement and is now considered 'over-bought'. This prompts the trader to initiate a sell position.

When the market is ranging, having an indicator that can help traders make entries within that range can be quite advantageous.

On the other hand, when the market is ranging, traders may face unfavourable outcomes as prices continue to move in the trending direction. This can put those who have opened trades in the opposite direction into a compromised position.

Pros and cons of the RSI

Conclusion

Understanding the RSI can provide valuable insights for traders, allowing them to anticipate potential shifts in market momentum or price pullbacks.

Technical traders can make informed decisions about their trading strategies when they properly analyse the RSI and other indicators. This includes identifying entry and exit points, deciding whether to buy or hold, or considering shorting positions. RSI is applicable in a wide range of markets, such as stocks and forex.