Our last four blogs have been about trend technical indicators. We have discussed Moving Average Convergence Divergence (MACD), Moving Averages, Bollinger Bands, and Ichimoku Kinko Hyo. You have learned how to use those indicators to build working trend-based Forex trading strategies.
However, you must note that trend trading, as a method, is multifaceted. There are other technical indicators that do not precisely fit into the ‘trend’ category, these can be described as oscillator or momentum indicators. The Relative Strength Index (RSI) is an example of one of these indicators.
Widely applied in Forex trading, the Relative Strength Index (RSI) was developed by J. Welles Wilder in the late 1970s. Being an oscillator indicator, it is based on a range of values between 0 and 100. Because it moves in between these two extremes, it is easily used to gauge both oversold and overbought market conditions.
This is how. A reading of 70 or above on the RSI spectrum indicates an overvalued and overbought market condition. So, you might expect the trend of the currency pair to soon reverse. Otherwise, an RSI reading of 30 or below means that the currency pair being analysed is undervalued and most likely oversold.
Relative Strength Index (RSI)
The Relative Strength Index (RSI) is arguably one of the simplest technical indicators to use. Primarily, it is based on momentum. That is, the strength of price. As a result, it can detect when the market is either bullish or bearish. That is, what is the momentum of the price? Is the market going up or down? If so, how strong is it going in that direction?
When the Relative Strength Index (RSI) reads 70 or above, the market is considered overbought. Conversely, when it indicates 30 or below, it is oversold.
A bullish momentum means the price is rising. Conversely, a bearish one means that it is falling. Momentum, generally, is like catching a ride on a train. Imagine you being able to do so right from when it is just moving and accelerating. As it moves forward, you can catch all the fun. However, it would also be best if, by the end of the ride, when it starts to slow down, you are already off.
It is this price momentum that the Relative Strength Index (RSI) uses to evaluate the market as either overbought or oversold. It does that by measuring both the magnitude and the direction of recent changes in the price of a currency pair – or any other financial asset to which it is applied. Traditionally, when the indicator has a value of 70 or above, the asset is considered overbought. Otherwise, when it is 30 or below, it is taken as being oversold.
RSI readings are calculated using some specific formulas. Those values rise as the number and size of market closing prices rise. Correspondingly, they fall as the number and size of negative closes increase. The RSI line is plotted in another chart beneath that of the asset itself. So long the market is strongly trending, RSI readings can be comfortably relied upon.
How to Use Relative Strength Index
So, how exactly do you use the Relative Strength Index (RSI)? Actually, if you are a trader who is not interested in complicated calculations, the RSI is arguably the best indicator for you to use. The reason is obvious: by just sticking to the following rules, you can use it to identify and capture excellent opportunities:
Step 1: Check the reading of the RSI chart. Is it 70 or more? The particular asset under study is most likely already overbought. Is it 30 or less? It is oversold.
The Relative Strength Index (RSI) helps to indicate overbought and oversold market conditions. ©️Babypips.com.
Step 2: When it is the former, you can expect a bearish reversal soon. If it is the latter, you can expect a bullish reversal.
Step 3: Hence, for the first scenario, get ready to sell. For the second, get ready to buy.
Step 4: Finally, while using the RSI, ensure to guard against false signals. Importantly, you should watch out for sudden, sharp price movements as they can make its readings erratic.
Because of its emphasis on momentum, the Relative Strength Index (RSI) can correctly gauge the strength – weakness or otherwise – of price. As a result, it can be effectively applied for the detection of prevailing market trends and reversals or pullback. All you need to check is the reading on its scale. Is it 70 or more, or is it 30 or less?
Relative Strength Indicator (RSI) is an oscillator and momentum indicator. As a result, it works fine for measuring the strength of price. Momentum is the velocity of the changes in the price of any financial instrument. Velocity because the direction of those price changes is equally important as their magnitude. That is, is the price going up or down? Whichever the direction, an RSI trader is keen on measuring the size of changes in price.
For you to start trading with Relative Strength Index right away, here, we have discussed all you need. A reading of 70 or above on the RSI indicates that the market is overbought and overvalued and so you should be getting ready to sell. One of 30 or less means precisely the opposite: the market is oversold and undervalued, and so you should look forward to buying. Nevertheless, with the indicator, you can be creative. That is, you can feel free to use it with any other suitable indicator too.
However, we equally understand that you might still not be willing to go through the rigours of analysing overbought and oversold market conditions using the indicator yourself. In that case, at 1000pip Builder, we have got you covered. Just subscribe for our Forex trading signals here.