Forex Trading: Learn how to invest in Forex with the RSI indicator

Posted on November 14, 2009
Filed Under Day Online Trading, Forex | Leave a Comment

The RSI Indicator is?

RSI is an oscillator indicator used for technical analysis and it means relative strength index.

In June of 1978, Welles Wilder developed the Relative Strength Index, providing step by step instructions and full explanations for its use. It caused hundreds of of forex traders to use it and thousands more still use it today obtaining good results.

RSI is an indicator that compares a given time, the individual moves up or down in the market and identify overbought and oversold conditions of a given pair. The RSI is an oscillator that provides trade signals before they occur in the market.

Therefore, the RSI allows you to compare the two averages and it is expressed as a percentage. If the average of low and highs are equal, the RSI has a value of 50%, this means that the relative strengths are balanced. However, if the value of the RSI is above 50% it means that there is more rising strength than relative bear strength, and if it is less than 50% it means that there is more bearish strength than bullish.

The RSI is considered to work most effectively in ranging markets (none trending), but you must remember that as any other technical indicator, signals must be confirmed with other indicators for them to work optimized.

Using the following formula we calculate the RSI:

RSI = 100 – 100
______
1 + RS

RS = Daily Average of upward closures / Daily Average of Downward closures

Learn how to use the RSI?

The RSI is characterized by the tendency of prices and moves, and runs from 1 to 100. By using this flag you must set two limits: an upper and a lower one, which mark overbought (70-80) and oversold (30-20) areas.

The RSI serves as an indicator of overbought / oversold values, which happens when it reaches one of the limits that traders program, so it is the line above or below the graph. The reason for this is that you buy when the RSI crosses the oversold boundary and you sell when the RSI crosses the overbought limit and starts to turn back down.

When the RSI line exceeds the 70% value it is considered to have entered an overbought zone. However, it is below the 30%, this will mean that the value has entered an oversold zone.

Also, in major movements or strong strengths, the RSI can quickly achieve overbought or oversold values. Therefore, if we applied the strategy mentioned above when the oscillator reaches the limits of overbought / oversold territory it would takes us prematurely out of a trade. A trade that has not yet been exhausted or has just begun. In these cases it is better to use the RSI Indicator to detect divergences between currency pairs.

The most common configuration for the RSI is to use in a 14 day period, although periods of 9 and 25 days have recently gained popularity. 14 days is recommended because it is more likely to give us real signs, since if you drive a smaller, for example 7 days, they can provide false signals. If, by contrast, uses longer periods, you may lose the real signals that occur within a shorter time period and give late signals but you will have to experiment to get the results you want which mix with your style of trading

The RSI offers 3 types of signals:

1. Divergence
2. Patterns
3. RSI Levels

• Divergence: It shows when the trend has ended or is exhausted and is ready to reverse. Divergence can be divided into upward and downward divergence. Divergence provides the strongest signals to trade. This signal presents itself when prices levels reach a higher height, but RSI indicator doesn’t.It is the same way when divergence occurs when a pair´s price reaches lower levels, but RSI does not.
• Patterns: This refers to finding and identifying patterns in the indicator, rather than on prices.
• RSI Levels: RSI measures overbought and oversold levels. It is considered the easiest to interpret and contrary to popular belief this is the worst way to use RSI, because this method provides too many false signals.

What a Forex Trader should NEVER do?

• Never buy when the line drops below 30. You must wait for it to cross back up.
• You should never sell when the line crosses over the 70 area. You must wait for it to drop back down.
• Do not trade when the indicator enters the overbought area or over sale, rather do it when you leave those areas confirmed with other indicators.
• Never take decisions on any technical indicator alone. Wait for other technical confirmations.

Remember that no investment is risk-free and an RSI indicator in Forex will help you most effectively when used in conjunction with other tools of technical analysis.