How to Use Relative Strength Index (RSI) in Forex Trading - ForeXposed


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Saturday, September 9, 2017

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

How to Use Relative Strength Index (RSI) in Forex Trading
If applied on MetaTrader 4, looks like this:
How to Use Relative Strength Index (RSI) in Forex Trading
We can use Relative Strength Index (RSI) to knows the following:

  1. Read the positive/negative divergence. 
  2. Read the momentum of price movement. 
  3. Read the overbought/oversold conditions.

However, among the three usabilities, the first usability is the most often used by traders, this is because it’s simpleness, so the interpretation of RSI is unbiased, one trader with another's.

How to identify overbought/oversold conditions using RSI is very simple. Simple, but not necessarily easy. A general rule that applies in overbought conditions is obtained when the RSI crossing 70 lines. The oversold obtained when RSI crossing 30 lines. Some of the book's authors on technical analysis also recommends that 20 - 80 as the oversold and overbought limit. Could just for a specific currency, under certain conditions the limits on overbought/oversold is 40 - 60, so depends on what is appropriate. Need to do trial and error. But as a little guide, RSI will be more accurate when used on the market condition that is efficient and stable. Until now, the forex market is a market which is the most stable and efficient in its movements (prices are largely determined by the market and highly liquid investments). So, more or less, 30 - 70 restrictions still apply here, although it is not absolute.

Look at the following chart:
How to Use Relative Strength Index (RSI) in Forex Trading
In the picture, the section shaded in yellow is the area of overbought and oversold on RSI, i.e. above 70 and below 30. Note When RSI is in these areas, the price will soon reverse like on the given circle. About how the price applies when the situation is overbought and oversold, we have been studying it in a previous lesson (Read: Trend, Support and Resistance, Overbought and Oversold). Interesting isn't it? An indicator capable of knowing when the prices will turn around! Thank J.W. Wilder for this.

The Centerline Crossovers

As on the MACD indicator that can be used to measure the power of increase/decrease price momentums, RSI can also be used for the same thing. The difference is if MACD crossover occurs at the zero line, then on RSI occurs at 50 line.

How to read the power of the price momentum is same as on MACD, i.e. when the RSI line broke through the centerline (50 lines) from the bottom then the trend is going up. The magnitude of momentum is the same to RSI values that occur. The case also applies vice versa. Let's clarify with one image:
How to Use Relative Strength Index (RSI) in Forex Trading
Note to the part labeled with the red circle. Appears when the RSI touching the centerline, from the bottom to the top then the price will move up, and vice versa when RSI line penetrate the centerline from the top to the bottom so the price tends to lead to a fall. There are certain situations where the signal is not valid, either because it is a false signal on RSI, which we will discuss at the subtitles after this. But with the centerline of this crossover, it will greatly help us in determining the buying and selling conditions.

False Signal on RSI

Do not use RSI indicators without reading this part!! Why? If you're pretty closely paying attention to the pictures presented above, surely some of you ask, why there are some circumstances where what is said is different to the RSI circumstances, actually?

This is called a false signal. If we trace the formula of RSI, first we will know that basically RSI moves is very sensitive. A sensitive indicator enables us to have plenty of advice for Buy/Sell according to the indicators. That's the advantages. Yet it also backfired for us, because with more recommendations exist, it will be more have a chance to giving misleading arguments, which can cause a great harm.

RSI has not used alone as the main indicators by the chartist, due to the sensitive nature of it. RSI is more often used as an amplifier the suggestion given by other indicators.

Then is there any way to eliminate the false signal on RSI, or at least to reduce the error signal from RSI? Of course, there is. The simplest way is to find the best periods in RSI that we use. As we know the greater the period of an indicator, then the nature of its sensitivity will be reduced. This also applies on RSI, that way we can use RSI with a more slightly period than usual, that is 14. We also can use above that period, for example, the 18 periods.
How to Use Relative Strength Index (RSI) in Forex Trading

Can you notice in the picture above how RSI 18 period (blue) looks more sluggish in accommodating the currency movements as compared to standard periods (14 periods).

Well, the period which is suitable depends on you, please to decide and trying each one. Usually, we are using 10 or 14 periods when using RSI, but I return to you as a reader.

The other way to reduce the sensitivity nature of RSI is trimming the parts of RSI that are too curly. Smoothing RSI with Simple Moving Average (SMA).
How to Use Relative Strength Index (RSI) in Forex Trading
In the picture above, I used SMA 3 period to smooth the RSI that is too curly. Look, that graph is now smoother, and we simply pay attention to the SMA on the RSI alone, to know the overbought and oversold conditions on RSI. In using SMA on RSI, we recommend not to use a period that greater than 5, because it will undermine the primacy of RSI itself, i.e. the sensitivity. So, just use the SMA 1 to 5 period.

The smoothing graph is very useful for RSI indicators that are often stopped briefly at the overbought and oversold areas, or just a momentary break through centerline. In this circumstances, the SMA will subside it, so that the curve becomes smoother