Reliability of a technical indicator has always been a yardstick to measure its effectiveness and utility in the realms of technical trading in the forex world. Forex trade is so fast paced and with such much of money at stake, speed and accuracy could be all that makes the difference between a good trade and an unsuccessful one.

So how do you choose and what are the forces that drive your choice in terms of the most effective technical tools? For an average forex trader, popularity as well as effectiveness almost go hand in hand because not only accuracy is important, sometimes for an average trader, the choice of the masses is like a reassuring force for them. In this popularity context, there is one indicator that wins handsdown, and it is known as the Relative Strength Index or RSI.

The RSI or the Relative Strength Indicator is a momentum indicator like the Stochastic Charts and is an extremely popular tool for determining trend patterns and deciding on entry and exit points in the market. Here is a detailed insight of the Why, how and what of the Relative Strength Index and how you can derive maximum benefit by using this technique.

Definition Of Relative Strength Index

Essentially the Relative Strength Index does a comparative study of the extent of recent gains and losses and uses that data to decide on the extent of fair value of a given currency pair. It is on the basis of this data that the traders can determine whether a particular entity is oversold or overbought. and then they can take a stance accordingly on how to extract the best from a given scenario.

The formula that is employed to determine the Relative Strength Index depends a lot on the average closing rate of the currency pair under consideration.

The formula essentially is

RSI = 100 100/(1 + RS*)

In this case *Where RS stands for the average of a specific number of days when the rates closed up divided by the average of equal number of days that the entity closed lower.

However you must have already understood that the biggest fallacy in this kind of technical indicator is the fact that any potentially large spike or nosedive in prices will significantly alter results for a given period and can also potentially give false signals that might eventually prove detrimental to the eventual trading position and your investment in the forex market.

The RSI normally, therefore, works best when used in collaboration with other tools for deciding the trend or determining the buy and sell signals. The RSI is essentially charted on a scale of 0-100 with the extreme ends signaling the overbought and oversold market conditions. The Overbought condition is seen 70 to 100 and oversold position starts from 30 and moves downward. Depending on the given market move, one can also choose to alter the readings to a scale where 80 and 20 become the deciding points for a market move, 80 standing for overbought and 20 the vice versa, oversold conditions. This becomes crucial as the investor gets fundamental clarity of determining the buying and selling point to enter or exit the market: RSI As A Great Overbought Oversold Indicator For Forex Trading

History Of The RSI Chart

The RSI was conceptualized and created by Welles Wilder in 1978. He mentions it for the first time in his book. New Concepts in Technical Trading Systems. Essentially this assigns value to a specific currency pair depending on the market trend and the direction of trade at a specific period. As a result of this, the RSI is plotted on a scale of 1-100 with every milestone giving an independent trading signal and helping you determining your trading stance on the basis of these signals.

I have already elaborated on the oversold and overbought conditions; the centreline, therefore, is the 50 mark on the scale. A crossover or breach of this level is crucial for the money market. A movement below this centreline from above it is seen a beginning of downmove trend in the market. The reverse signals upmove when we see movement from below the centerline to above it. So not only do you get an idea about the existing patterns, but also an ideal time and market conditions under which you must exit or enter or make alterations in your position.

How to Use Relative Strength Index in Forex Trading

Well, this then essentially brings us to the next pit stop in terms of expanding our assessment of the Relative Strength Index. How do we use this widely acclaimed accurate indicator to maximize the gains on our investment in the forex market?

The RSI gives you clear and precise trade signals that are extremely simple to interpret and execute in your day to day trading action.

Starting from the bottom of the chart, a 0-30 reading stands for oversold conditions thus this becomes the cue for the trader to make an assessment of the point of reversal in the forex market and for the specific currency pair. This essentially this is a bullish signal for the forex market traders and help them to decide on a potential entry point in the market. Thus, this becomes the buying zone in the market.

Meanwhile, when the RSI slips to the other end and the value falls in between 70-100, you have the overbought condition and another point of reversal in the market. It signals the currency pair has hit its roof, and the prices are set for a downward move. In other words, this is the sell signal for the market, and the trader can start initiating the exit strategy at this point. Thus, the top end stands for the bearish end on the chart.

Now we reach the centre point and the strategy when the Centerline is breached. Movement of the graph above the centreline from below it towards the 70 mark stands for a situation where the market is gradually approaching tricky territory and the trader should make preparation for eventual exit and preserving the precious profit. On the contrary when this line moves from above 50 to below towards the 30, the market is bracing up for a reversal and potential upmove in times to come and cue for traders to start making provision for heightened investment at the right point.

Therefore, the basic usage of this indicator is identifying potential price reversals as well getting an idea of prospective price points that would signal a reversal in the market. Whether looking for price point to buy around the 30 mark or sell around the 70 levels, the RSI comes handy in raising the first point of alarm in terms of determining when to brace up for a change in trading stance and how best to preserve profits or limit losses.

Advantages Of Using The Relative Strength Indicator

Onto the study of the pros and cons of using this simple indicator to assess the market position, here are the broad positives first:

1. Ease Of Usage: This tool is extremely simple to use and can be put to use by a wide cross section of users. Starting from new comers in the market with limited trading experience to veterans who have been facing the challenges of the forex market for years, the appeal of the Relative Strength Indicator transcends all trading classes. Whether used with along with other technical tools or on a standalone basis, the RSI helps you identify the broad trends and get a fair idea of the entry and exit levels.

2. Simplicity Of Charting: The formula used for charting the Relative Strength Indicator is quite straightforward. It does not need any complicated mathematical derivations to reach this point, and the trader can easily draw his or her conclusions on the basis of some basic data points. Also, the data points being as basic as the closing rates for a specific time period, it is not hard to source to them. Moreover most trading platforms have automatic RSI calculators which make following this indicator as simple as it could be ever imagined.

3. Accuracy Factor: The Relative Strength Indicator charts are considered to be amongst the most accurate ones in the overall scheme of things. If charted carefully and interpreted cautiously they can be one of the best indicators of the market momentum, the developing trend and the potential pattern in which trade is expected to pan out during the course of the time period for which the chart is plotted. Also the fact this employs fairly simple data points to arrive at the desired results, the chances of false buy or sell signals being generated is fairly limited to times when there is sudden upheaval in the world of forex trade. These are rare occasions when an intelligent trader combines the RSI findings with the result of some equally strong technical tools and backs it up with strict stop losses.

Problems Or Concerns While Trading Using The Relative Strength Indicator

Though, it is quite a popular tool for forex trade analysis, there are some fundamental flaws seen here.

By the sheer way in which the RSI is plotted, it generally looks for points of reversal in a trading scenario. The oversold and overbought regions being the marquee points in the mapped price action and continue to be the hallmark of the trading action. When the chart moves towards 30, it is time to enter, and when the upmove reaches close to 70, it is time to sell or exit positions.

In a ranging market where pricing action operates within a decidedly narrow range it can be the weapon of choice but when very volatile and sharp wings are seen during the course of trading, the outcome of the RSI chart can be exceedingly confusing to say the least. The sudden spike or absolute nose dive in rates can yield false buy sell signals within the same time period. This can be instrumental in creating chaos in the market place and can even lead to wide spread panic and euphoric swings in the market.

Also, many a times traders forget to keep strong stop losses in place. That can be extremely detrimental towards your investment when you are using a momentum oscillator like RSI. Since the trading directives and trends are so straight forward and direct, there is no place to hide in between. So if a trader is not careful in managing the positions, RSI can wreak more havoc than gains.

More Applications of RSI in Forex Trading

Here is some more articles about using RSI in different occasions and situations or different trading styles:

Concluding

Some basic facts need to be clear in a trader’s mind. The popularity of an indicator and accuracy are not always interlinked. The accuracy depends much on the exact trend /pattern that you might be trying to analyse and depending on the various parameters that you might employ to reach such a conclusion. The change in parameter or a sudden, unusual movement in prices with the specific time period you might be taking into consideration can greatly alter the results and signals that you could deduce from a given set of data.

Another important factor that you must never lose sight of is, ‘past prices can never predict future price action .’ All it does is gives you an idea about how it might move given how it performed the last time around the same levels. Thus, no indicator will ever help you predict the future perfectly. It can only help you brace up for a potential scenario and what it might entail given the movement that was seen the previous time round.

That said the RSI continues to be among the most reliable indicators for assessing the strength of the market trends that might be underway currently and gives a broad perspective on how to trade every new price point. Essentially if the specific trend might continue or if a reversal is in the works.

Remember that risk management remains your key word and trading without stop loss can be well termed as suicidal in many of these instances. Effective risk management comprises of a strategy where not only do you go with the trend but also put effective stops at every price point. Another important fact that a trader must always remember while using the RSI, or the relative trade indicator is that trend confirmation is very important. They must use another technical tool to confirm the trend that RSI charts might be suggesting. In this way, they will be able to avoid any potential false signals that might be generated due to unusual price movement in the time period they might be considering while charting the movement of a specific currency pair.

So almost like crossing the road when you  look right and look left, take the RSI, confirm the broad trends. put stops in place and go ahead with your trading positions.

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