Different uses of RSI in forex

The Relative Strength Index (RSI) is one of the most widely used technical indicators by traders.

The RSI is an oscillator because it is an index whose value tends to swing between an upper limit value and a lower limit value. It is used primarily to help identify overbought or oversold conditions in a particular currency, as it is formulated to fluctuate between 0 and 100, enabling fixed overbought and oversold levels.

It does this by confirming changes in momentum which signals an imminent change in price direction or trend for the particular currency.

The advantage of the RSI over other oscillators such as the Momentum or Rate of Change oscillators, is that it is smoother and is not as susceptible to distortion from unusually high or low prices


If used properly, the RSI is a very valuable tool in interpreting chart movement.
We could list out the brief points of this indicator as follows –

  • It is a momentum indicator, which oscillates between a scale of 0 to 100.
  • Its two basic functions to interpret price movement are the overbought/oversold levels, and divergence.
  • It also identifies price movement by forming patterns such as a double top/bottom, head & shoulders etc, when the same would not be clearly visible in the price movement. Similarly areas of support/resistance found on the RSI, prove to be more effective.
  • It would generate more precise signals when the market is in a range bound state. Here, the overbought/oversold levels as well as divergences show up more accurately on the RSI.
  • When price is trending, it would give false signals since it remains in the overbought/oversold state for an extended period of time.

Let us examine the interpretations in detail with examples to get a better idea –

1.Overbought and Oversold — these are often indicated when the index goes above 70 or below 30. The index will usually top out or bottom out before the actual market top or bottom, giving an indication that a reversal or at least a significant reaction is imminent


Chart

We can see that the price was in a strong downtrend. The RSI bottomed out below the 20 level, and started rising giving the indication before the price.

2. Divergence — Divergence between price action and the RSI is a very strong indicator of a market turning point and is the single most indicative characteristic of the RSI. Divergence occurs when price is making a new low, but the RSI is failing to exceed its previous low. This "divergence" is an indication of a coming reversal.


Chart

3. Chart formations — the index will display graphic chart formations which may not be obvious on the price bars. For instance, head-and-shoulders, tops or bottoms, pennants or triangles often show up on the index to indicate breakouts and buy and sell points.


Chart

Here the RSI forms a double bottom, when price does not give any indication of the same.

4. Support and resistance — Areas of support and resistance often show up clearly on the index before becoming apparent on the bar chart.


Chart

As mentioned above, the basic drawback of this indicator is that it loses its effectiveness in trending markets. While it is one of the most effective indicators for ranging markets, it should not be relied upon when the market is in a trend. This is because the RSI tends to remain in the extreme zones during a trend, giving false overbought/oversold signals.

But we can use the RSI to give us a different interpretation, namely that to determine breakouts.

Price action can be classified into two general conditions - range bound and trending.

A range bound market tends to remain between defined support and resistance levels, and fails to trade to new highs or new lows. A trending market on the other hand, tends to trade to new highs or new lows, and may extend for a significant period of time. As the market approaches a significant high, we may either decide to sell anticipating the range bound condition to continue, or buy anticipating a breakout.

In such situations it becomes a difficult task to determine if the current range will continue or a new trend will emerge?


Here we can use the RSI to help us in our quest.

The RSI is very well suited for this, because of its ability to normalize price data providing a much smoother and often better picture of the true price action.

In fact, in FX where volume data is usually not available, the RSI can be used as a proxy for volume with large upward spikes in RSI indicating strong buying. The RSI plotted on a scale of 0-100 measures the current market price in contrast to its average price, and helps us identify relative overbought and oversold conditions.

Typically a reading above 70 indicates an overbought state, and a reading below 30 indicates oversold regions. In a range bound price action, we would typically go long as the RSI dips below 30 and crosses back above it, and take short positions as the RSI rises above 70 and crosses back below it. This approach generally tends to generate profitable returns as the FX markets tend to remain in a range the majority of the time.

However, as the market breaks out of its range to a new trend, and as the RSI crosses above 70, the market will also break resistance and trade to new highs.

Hence, if we have an indication of a breakout, we should look for confirmation not only on the RSI, but also in the price action.

We may define the parameters of this strategy as –

  • If the RSI breaks above 70 and the market fails to break above a resistance level, the current range will tend to continue.
  • However if the market trades to new highs, breaking a previous resistance level as the RSI crosses above 70, a new trend to the upside is strongly indicated.
Trading these simple horizontal trend line breaks, which denote support and resistance, provide us with high-probability set-ups.

The following chart example shows this strategy

Chart

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