Leveraging the benefits of the Relative Strength Index (RSI) in forex trading is easy when you know how to go about it. All it takes is a keen eye and in-depth understanding of how this particular indicator works. It may also require the utilization and analysis of other key indicators for surety. In this article, you will get to learn everything about the RSI – what it is, how it is used, and its complementary indicators.
What is the Relative Strength Index?
The RSI is one of the common indicators popular among forex traders. Like other indicators, it is designed to aid with analysis and help traders place accurate trades. In some ways, the RSI functions in a similar manner to the stochastic indicator in that it identifies oversold and overbought currencies – it helps to identify tops and bottoms.
The RSI is scaled from 0 to 100, and the key readings are divided into four main categories. Two of these categories have to do with oversold and overbought market conditions – readings below 30 indicate oversold conditions while readings above 70 indicate overbought conditions. The third and fourth categories split the range in half – readings above 50 indicate that there is a possible uptrend while readings below 50 indicate otherwise.
Using the RSI in Forex Trading
It becomes easier to analyze the RSI with the aforementioned categories in mind. The following is a look at what each of these categories does, and how you should apply them in the market:
- Below 30 – Oversold
- Above 70 – Overbought
- Below 50 – Possible Downtrend
- Above 50 – Possible Uptrend
Consider a EUR/USD trade. Taking the normal fluctuations into consideration, should the RSI drop to below 30 then it is an indication that the pair has been oversold and it is highly likely that there are very few sellers left to fuel the current downtrend. In this case, this is an indication that the current downtrend may be over, and the ideal response is to bank on an uptrend as the price will likely reverse.
Sticking with the EUR/USD trade, an RSI rise to above 70 is an indicator that the pair has been overbought. This means that there are too few willing buyers in the market to sustain the uptrend and is an indicator that prices will reverse soon. Ideally, a smart trader would bank on a downtrend.
Getting in on the right trend at the right moment is often rewarding. The RSI also comes in handy when determining whether a trend is forming and whether it will hold. Readings below 50 are an indication that a downtrend has been forming and likely has a strong momentum that will hold for some time. Readings above 50, on the other hand, show that an uptrend has been forming and will likely hold for some time depending on the market’s volatility. One tip that you should remember is that it may become necessary to adjust the overbought and oversold readings to 80 and 20 depending on the market conditions.
Complementary Indicators To Use In the Forex and Stock Market
Like many other indicators, the Relative Strength Index also has shortcomings that compromise its accuracy. The forex and stock markets need deep analysis and thus require a wider analysis. It is for these reasons that additional indicators become necessary when analyzing using the RSI. Several indicators help complement the RSI, but none is as convenient as the following two:
- The Moving Average Convergence Divergence
- The Average Directional Index
If the MACD shows divergence from price, then this is an indication that a retracement is imminent and trade is profitable. Divergence would come up if, for instance, the price makes a new high but the MACD turns from a downward slope to an upward one.
The Average Directional Index (ADI)
If the ADI matches the direction of a possible retracement, then this is an indication that a trade would be rewarding. One vital tip you should consider is that in addition to these signals, you may also need to use a stop-loss order just beyond the low and high prices just to be safe.
Forex and Stock Trading – A Lucrative Endeavor
Trading stocks and forex is not a privilege for a select few as the common misconception goes. Anyone can do it given the right know-how and resources such as the RSI and other indicators. It is a lucrative endeavor that enriches and enlightens, and you have nothing to lose by giving it a try.