Relative Strength Index: How to Trade with an RSI Indicator
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This article explores how to trade with the Relative Strength Index (RSI), highlighting why traders use this indicator, what the indicator is and what it is for, as well as looking at topics such as RSI trendlines and RSI Two Period Divergence.
Technical analysis is a method of predicting price movements and future market trends, by studying charts of past market action, and comparing them with current ones. Technical analysis is concerned with what has actually happened in the market, and what might happen. It takes into account the price of instruments, and creates charts from that data to use as the primary tool. One major advantage of technical analysis is that experienced analysts are able to follow many markets and market instruments simultaneously.
There are three main principles in technical analysis that should be covered before taking a precise look at the RSI indicator:
1. Trend is your friend
Technical analysis is used to identify patterns of market behavior that have long been recognised as significant. For many given patterns, there is a high probability that they may produce the expected results. Additionally, there are also recognised patterns that repeat themselves on a consistent basis.
2. History repeats itself
Forex chart patterns have been recognised and categorised for over 100 years, and the manner in which many patterns are repeated leads to the conclusion that human psychology has changed little over time.
3. Price Action discounts everything
This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and market sentiment. However, pure technical analysts are only concerned with price movements, and not with the reasons for any changes that may occur. One of the indicators that technical analysis is very reliant on is RSI – the Relative Strength Index Indicator. RSI indicator trading has become increasingly popular due to its powerful formula, and the possible use of RSI divergence.
What to Know About the RSI Before You Start Using the Indicator - The RSI Indicator Fundamentals
What is the RSI indicator?
The RSI measures the ratio of up-moves to down-moves, and normalises the calculation so that the index is expressed in a range of 0-100. It was originally developed by J.Welles Wilder. If the RSI is 70 or greater, the instrument is assumed to be overbought (a situation whereby prices have risen more than market expectations). An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation in which prices have fallen more than the market expectations).
Contrary to popular opinion, the RSI is a leading indicator. The formula for the RSI indicator takes two equations that are involved in solving the formula. The first component equation obtains the initial Relative Strength (RS) value, which is the ratio of the average 'Up'' closes to the average of 'Down' closes over 'N' periods represented in the following formula:
- RS = Average of 'N' day 's closes up / Average of 'N' day's closes down
The actual RSI value is calculated by indexing the indicator to 100, through the use of the following formula:
- RSI = 100 - (100 /1 + RS)
If you are using MetaTrader (MT4), you can attach the indicator on your MT4 chart, and simply drag and drop it to the main chart window. The GIF provided below demonstrates this process:
Source: MetaTrader 4 - RSI Indicator selection
Here are some examples of trading strategies you can use with the RSI indicator:
RSI Indicator Trading Strategies
RSI OBOS Levels
If the RSI is less than 30, it means that the market is oversold, and that the price might eventually increase. Once the reversal is confirmed, a buy trade can be placed. Conversely, if the RSI is more than 70, it means that it's overbought, and that the price might soon decline. After a confirmation of the reversal, a sell trade can be placed. The 50 level is the midline that separates the upper (Bullish) and lower (Bearish) territories. In an uptrend, the RSI is usually above 50, while in a downtrend, it is below 50.
Source: Example of MetaTrader 4 - Mini Terminal - EURUSD - Data Range: 7 Mar, 2017 - 8 Mar, 2017
RSI Two Period Divergence
Apply a short 5 period RSI (RSI 5) over the longer (default) 14 period RSI (RSI 14) and watch for crossovers. With the RSI 14, there are times when the market does not reach the oversold or overbought levels before a shifting direction occurs. A shorter period RSI is more reactive to recent price changes, so it can show early signs of reversals. When the RSI 5 crosses above the RSI 14, it means that recent prices are getting higher.
A buy signal is then generated, and a 5 vs. 14 cross should happen when the 5 period (blue) is oversold (below 30). When the RSI 5 crosses below and becomes lower than the RSI 14, it means that recent prices are declining. This is a sell signal. A 5 vs. 14 cross should occur when the 5 period (blue) is overbought (above 80). Experienced traders may find that their trading performance greatly benefits from combining a RSI trading strategy with Pivot Points.
Source: Example of MetaTrader 4 - EURUSD - ECN Hourly Chart - Data Range: 27 Jan, 2017 - 8 Feb, 2017
Connect tops and bottoms on the RSI chart itself and trade the trendline break. To draw an RSI uptrend line, connect three or more points on the RSI line as it rises. A down trendline is drawn by connecting three or more points on the RSI line as it falls. The break of an RSI trendline might indicate a potential price continuation or a reversal. Bear in mind that the break of an RSI trendline usually precedes the break of a trendline on the price chart, thus providing an advance warning, and a very early opportunity to trade.
Source: Example of MetaTrader 4 - EURUSD - ECN Hourly Chart - Data Range: 21 Feb, 2017 - 3 Mar, 2017
RSI Classic Divergence
RSI bearish divergence forms when the price forms a higher high, and at the same time the RSI decreases, and forms a lower high. You will usually see RSI divergence forming at the top of the bullish market, and this is known as a reversal pattern. Traders expect the reversal when the RSI Divergence forms. It is an advance reversal warning, as it appears in several candlesticks before the uptrend changes its direction, and breaks below its support line.
Conversely, the RSI bullish divergence will form when the price forms a lower low, and the RSI forms a higher low. This is an advance warning sign that the trend direction might change from a downtrend to an uptrend. RSI divergence is widely used in Forex technical analysis. Some traders prefer to use higher time-frames (H4, Daily) for trading RSI divergence. Using these strategies, you can achieve various RSI indicator buy and sell signals.
Source: Example of MetaTrader 4 - EURUSD - ECN Daily Chart - 23 Jun, 2016 - 27 Feb, 2017
Conclusion: RSI Forex Trading
It is so simple to jump into trading using the Forex RSI indicator, that novice traders often begin trading without testing different parameters, or educating themselves on the proper interpretation of an indicator, because of the desire to grab money quickly! As a result, the RSI has become one of the most widely misused MT4 indicators. Once understood and correctly applied, the RSI has the ability to indicate whether prices are trending, when a market is overbought or oversold, and the best price to enter or exit a trade.
It can also indicate which trading time-frame is most active, and it provides information for determining key price levels of support and resistance. The RSI can provide you with technical trend information, as well as RSI buy and sell signals. It is crucial that you practise RSI trading strategies on demo account first, and then apply them to a live account. Additionally, the RSI strategies can complement any Forex trading strategy that you may have already been using.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.