Best Relative Strength Index (RSI) Trading Strategies in Forex

The Relative Strength Index (RSI) is one of the most popular indicators in the market. The RSI is similar to Stochastic in that it identifies overbought and oversold conditions in the market and offers a chance to define the market sentiment . This instrument can also be used to detect times when the price is about to reverse, and a new trend rises.

The RSI always be used in a combination with another Forex trading tool or technique for confirmation. In this lesson, we will dissect the RSI indicator and give some best practices for trading with it.

Relative Strength Index (RSI) Definition

Developed by Welles Wilder in 1978, the RSI indicator is a momentum oscillator that is used in technical analysis to quantify the speed and price movements of the stock or other assets.

It also has a reading from 0 to 100. Notice traders will frequently use the ‘mid-line’ at 50 as a cut-off. If the RSI is reading above 50, traders will consider the trend to be bullish. If RSI is below 50, traders will often consider the momentum to be bearish.

Further, traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.

Some traders interpret that an oversold currency pair is an indication that the falling trend is likely to reverse, which means it’s an opportunity to buy. And an overbought currency pair is an indication that the rising trend is likely to reverse, which means it’s an opportunity to sell.

But a weakness of the RSI is that sudden, sharp price movements can cause it to spike repeatedly up or down, and, thus, it is prone to giving false signals. However, if those spikes or falls show a trading confirmation when compared with other signals, it could signal an entry or exit point.

It is not uncommon for the price to continue to extend well beyond the point where the RSI first indicates the market as being overbought or oversold. For this reason, a trading strategy using the RSI works best when supplemented with other technical indicators to avoid entering a trade too early.

Best Relative Strength Index (RSI) Trading Strategies

1. RSI Divergence Trading Strategy

Another great use of the Relative Strength Index is to watch for divergences between the RSI and the price of the currency pair. This trading strategy enables you to identify divergences in the market that provides advanced signals of reversals. When the RSI is not in line with the price movements a reversal in trend is expected. There are both bullish and bearish divergences:

A bullish divergence occurs during a downtrend, when the price makes lower lows but the RSI makes higher lows. As price and the RSI indicator should move in the same direction, if the indicator fails to make a lower low this is a sign that the trend may reverse.

A bearish divergence occurs when price creates higher tops on the chart, while RSI is giving you lower tops. After a bearish divergence, price usually makes a rapid bearish move.

2. RSI Two Period Divergence

This strategy makes use of two different RSI based on different periods. A shorter RSI is more sensitive to price changes and gives early signs of reversal. When the shorter RSI crosses over the longer RSI, it signals the buy and sell opportunities. When the short-term RSI crosses above the long-term RSI, it indicates that prices are rising and when the short-term RSI crosses below the long-term RSI, it indicates that prices are falling.

For example, one long-term RSI, with a period of 14, and one short-term RSI, with a period of 7 cross as below, indicating a buy signal and sell signal:

3. Compound RSI Strategies

A compound strategy is when you use two indicators together. It is always advised to balance the signal of one indicator against another, this will help to cut out a lot of false signals. There are a few indicators that pair well with the RSI and using them together can proved better trading signals, including candlestick, MACD, MA, Bollinger band and so on. For example, we combine the RSI indicator with the 9-period and 15-period MAs:

We will buy or sell when we match an RSI overbought or oversold signal with a supportive crossover of the moving averages.

As the chart above, we spot a bearish divergence between the RSI and the price and later the short term MA crosses below the long term MA, which is a very strong exit signal, and we immediately close our long trade.

And then a bullish divergence forms, following which the short term MA crosses above the long term MA, this is a strong entry signal and we should buy the currency pair.

Conclusion

RSI measures the relative strength of the market, making this oscillator an invaluable tool that can be employed in virtually any market. It has multiple benefits but the primary benefit it provides is its versatility.

Of course, there are still some disadvantages that we need to discuss. For example, the drastic price changes can still cause the indicator to spike up or down, giving out false overbought or oversold signals. And the overbought/oversold conditions can last quite a while before the price starts to actually retract. For this reason, traders tend to use it alongside other indicators.