How to trade using Relative Strength Index (RSI)

Relative strength index (RSI) is a technical momentum indicator that was developed by J. Welles Wilder. To trade using RSI requires you to first understand the indicator’s major characteristics.

It is used to measure the strength of the upward movements and downward movements and identifies the overbought and over sold conditions on the market chart. It also compares the higher and lower closing prices.

Let’s look at the illustration below;

RSI scale ranges from 0 to 100% giving overbought and over sold signals.

When the RSI reads 70% and above shows that the market is overbought (bearish reversal) and indicates oversold conditions when the RSI is below 30% (bullish reversal).

Above 70% shows that price is likely to fall and at 30% and below indicates that price is likely to rise.

When the RSI reads  greater than 50, it indicates that the upward force is greater than the downward force so it is a strong uptrend and when it goes below 50 the downward force is stronger than the upward force therefore a strong downtrend.

RSI formula

RSI = (100—(100/(1+RS)))

Where RS is the relative strength

RSI = (14 EMA on last 14 up bars/14 EMA on the last 14 bars down)

It is set at 14 EMA (Exponential Moving average) default. 

How to trade using Relative Strength Index (RSI)

Buy when the RSI indicator reads 30% and below. This shows that the market is oversold.  Sell when the RSI reads 70% and above, market is under overbought conditions and is a good signal for a bearish reversal.

When the market is oversold the price are very low and most traders will buy currencies when prices are still low to sell at a higher price in future, therefore it is a good time to buy.

Before you enter any trade, you should first wait for price to move back to the direction you want to take.

For example your confirmation would be;

  • on the overbought, (sell) signal is a first fall in price below 70% before entry.
  • For a buy signal, enter after price has risen to atleast some candlesticks above 30% level

It is very important to get extra confirmation for the signals for example combining RSI with other indicators and candlestick patterns. We look at that in detail in our next sessions.

Note that we didn’t take the entries at A and B because the RSI didn’t go into the the overbought/ oversold condition zones.

Trading divergences using RSI

The RSI can also be traded by looking for bullish and bearish divergences between the RSI and the currency price movement.

If the price reaches higher highs but RSI is not able to to reach the new higher high, there is a bearish divergence. sell on completion of the divergence. If price reaches the new low and RSI fails, there is a bullish divergence. Buy after noticing this kind of divergence. Divergences are more significant after an overbought or oversold scenarios.

Let’s have a look at the GBPUSD, 4-Hour chart below.

Take a clear look at our chart above, note that the price at A and RSI all had clear lows, when price hit a new low at B, the RSI formed a high. This is a bullish divergence and indicates an uptrend trend hence a buy signal

Combining RSI with support and resistance is used with RSI

This commonly applies very well while trading ranging markets. As prices bounces off support and resistance levels in a range, watch RSI for overbought and oversold conditions.

Let’s take a look at the USDJPY Daily below;

Note that as price bounced off support the RSI showed oversold conditions, this is a buy signal. As price bounced off resistance, the RSI was showed overbought conditions, this is a strong sell signal.

 

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