Trading Forex with the Relative Strength Index Indicator

The Relative Strength Index(RSI) is another one of the popular banded momentum oscillators used by traders the world over, developed by J. Wells Wilder, it is similar to a stochastic in that it is used to identify overbought and oversold conditions as well as trend formations in the market.

The RSI measures extreme levels in financial markets by comparing recent gains to recent losses and plots the result on a graph in a banded range between 0 and 100. The indicator has three additional lines on it that are used by traders to identify potential market entry points.

The two outer bands set at 70 and 30 respectively and represent the OB/OS extremes. It also has a center line set at 50 and is used by many traders to identify a new trend.

Traders use the RSI in number of different ways to identify possible trading opportunities. The first of these methods is to identify when the market is OB/OS. When the RSI crosses above the 70 line the market is considered to be in an overbought condition and alerts traders to a possible reversal to the down side.

When the RSI line again crosses below the 70 line they short the market on a bearish reversal.

When the RSI crosses below the 30 line the market is considered oversold and traders await a cross back above the 30 line on a bullish reversal for a rally to the upside and enter the market long.

Center line

Many traders consider the market to be in an up trend when the RSI crosses above 50 and in a down trend when it crosses below 50. They only therefore enter a trade long when the RSI confirms a new trend by crossing above the center line.

Traders enter the market short when the RSI crosses below the 50 line confirming a new down trend.

This method however can be less reliable in a ranging market and the RSI can see saw above and below the center line causing many fake outs. This method is best used in conjunction with other indicators as confirmation to filter out the false signals.

Divergence

The third method of using the RSI indicator is to identify divergence. Divergence occurs in the market when price is heading in one direction and the indicator in the opposite direction.

This is often an indication that a reversal or continuation of the trend is about to occur, depending on the type of divergence. By identifying divergence the trader is able to take advantage and enter a trade at the earliest possible chance.

As with all indicators the RSI is subject to false signals and is best used in conjunction with other indicators to filter out the false signals. The attached chart shows all three methods of trading as well as the false signals generated.

Most modern charting packages allow the input values of the RSI to be adjusted to suit individual trading styles. Even with a standard 14 setting though we can see by the ragged lines that the RSI is quite sensitive to price change. By setting too low a value the sensitivity may cause may false signals.

Relative Strength Index Indicator Chart Example