How to Trade with RSI (Relative Strength Index)
The Relative Strength Index (RSI) is the most famous oscillators of them all. There is virtually no trader, either a Forex trader or any kind of trader in this world that didn’t hear about the RSI and its use in trading financial products.
So many theories have been written based on how the RSI is functioning and so many other oscillators have been built based on its structure, that out of all the oscillators to be found, most of them show the same thing like the RSI.
Therefore, whenever taking your entries and exits based on an oscillator, consider that it is like trading with the RSI. After all, all oscillators show the same thing: buying or selling in oversold or overbought areas.
The Relative Strength Index is an oscillator and therefore will appear at the bottom of the chart it is attached to. To apply the RSI to any chart, just select the currency pair you want to attach the RSI to, the timeframe, and then simply go on the Insert/Indicators/Oscillators tabs and chose the RSI. This is valid for the MetaTrader 4, as our whole Forex Trading Academy project is based on this trading platform.
From that oscillators list, you can see on the chart above, we’ve discussed a few here on our project, but keep in mind on thing: there is none more important than the RSI. If a trader understands how the RSI is travelling and its interpretation, then simply applying the same principle to other oscillators will have the same result.
By selecting the oscillator from the image above, a pop-up window in the middle of the screen appears and traders can choose the setups they want for the RSI, like the color and size of the line, the period the oscillator will take into account and one can even modify the levels the RSI will travel between. This can be done for any oscillator, so nothing new so far.
It is recommended to keep the 14 period, the default one as if the period is increased, the RSI line will flatten, while if the RSI period is decreased, the oscillator swings will be more aggressive and interpretation will be difficult. This doesn’t mean that the trader cannot play with the levels and the period in every way he/she wants.
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Ways to Trade with the RSI
Before moving on into how to actually trading with the Relative Strength Index, one needs to understand what the oscillator shows and what its standard interpretation is. The image below shows the oscillator applied on the four hours EURUSD chart and using the default settings offered by the broker, the 30 and 70 levels are predefined.
These are the levels where price is considered to be overbought (above 70) and oversold (below 30). If you refer to the DeMarker indicator presented here on our Forex Trading Academy project, you’ll see that similarities are remarkable, as DeMarker has the 0.3 and 0.7 levels to define overbought and oversold areas,
On the same line, the RSI travels between zero and one hundred and it is impossible at any one time to have negative values or values above the one hundred level. No matter how aggressive a move may be, those levels cannot be broken.
The following are three ways to trade using the RSI oscillator, and all of them are important for a trader, based on the trading style and the timeframe the oscillator is applied to. There’s not one approach more effective than another, there’s only one trader that pays more attention to details than another.
Trade Bullish and Bearish Divergences with RSI
The classical interpretation of the RSI oscillator is, as mentioned multiple times in this article, to sell in overbought areas and buy in oversold areas. This is valid for all oscillators and I’m not going to insist anymore on this subject.
This is now working one hundred percent of the times though as, when the market breaks out of an important consolidation area or when a surprising economic news is released, these areas are the ones where price is accelerating, not slowing down. These are the areas where market participants are being caught on the wrong side of the market and where margin calls are being triggered.
To avoid such a thing and to bring a little help from the technical analysis field, divergences between price and oscillator can be used. Divergences can be either bullish or bearish, and traders are looking for them to form in these areas.
A divergence is forming when the price is making two highs/lows, for example, and the oscillator is not confirming the second high. Ideally, for the signal to be strong, at least one of the two highs/lows should come in the overbought/oversold area.
A bullish divergence will have a bearish trendline on the actual price chart and a rising one in the oscillator window. The opposite is true for a bearish divergence, with a rising trendline on the oscillator chart window and a falling one on the actual price chart.
I’m not going to exemplify divergences with the RSI here as they are simply similar to the ones described in the article dedicated to the DeMarker oscillator here on the Forex Trading Academy. The purpose here is not to repeat things, but to explain them in such a way that they are properly understood.
Use the Fifty Level as a Continuation Pattern
Another way to trade Forex with the RSI oscillator is to actually use the fifty level as a continuation pattern. This means that if the oscillator is falling from the overbought area, by the time it is crossing the fifty level it should be a continuation signal for more downside.
The opposite is true as well, with the fifty level being a nice place to go long when the oscillator is travelling from the oversold area and breaks the fifty level to the upside. In order to see that on the actual oscillator window, the indicator needs to be edited and the fifty level added.
To do that, just right-click anywhere on the chart, select the RSI from the Indicators List, and under the Levels tab, you can enter the desired value.
These are just a few examples on how to actually use the RSI oscillator when trading but one should keep in mind that there are numerous trading techniques based on it. After all, there is no other oscillator so popular and famous than the RSI, so it is no wonder traders used it in their research.
Other educational materials
- Using Stochastics to Trade Forex Markets
- Finding Entry and Exit Levels with Momentum Oscillator
- Trade Forex with Volumes Indicator
- Bill Williams – How to Use Williams Indicators When Trading Forex
- How Do I Make a Profit from Forex Trading?
- Forex Market Terminology
Recommended further readings
- Forex forecasting The Wharton School, University of Pennsylvania
- An Automated Trading System with Multi-indicator Fusion Based on D-S Evidence Theory in Forex Market Zhihong Liu, Deyun Xiao, 14-16 Aug. 2009