RSI and Forex

The relative strength index (RSI) is most commonly used to indicate temporarily overbought or oversold conditions in a market. An intraday forex trading strategy can be devised to take advantage of indications from the RSI that a market is overextended and therefore likely to retrace.

The RSI is a widely used technical indicator and an oscillator that indicates a market is overbought when the RSI value is over 70 and indicates oversold conditions when RSI readings are under 30. Some traders and analysts prefer to use the more extreme readings of 80 and 20. 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.

Key Takeaways

  • The common levels to pay attention to when trading with the RSI are 70 and 30.
  • An RSI of over 70 is considered overbought. When it below 30 it is considered oversold.
  • Trading based on RSI indicators is often the starting point when considering a trade, and many traders place alerts at the 70 and 30 marks.
  • When the alert is triggered, the trader will examine the validity of a trade.
  • The RSI can give false signals, and it is not uncommon in volatile markets for the RSI to remain above the 70 or below the 30 mark for extended periods.

Identifying Trading Setups Using RSI

Here are some steps to implementing an intraday forex trading strategy that employs the RSI and at least one additional confirming indicator:

  1. Monitor the RSI for readings indicating the market is overbought or oversold.
  2. Consult other momentum or trend indicators for confirming signs of an impending retracement. For example, if the RSI shows oversold readings, a retracement to the upside is anticipated though not necessarily confirmed.

It is considered good practice to look at initiating a trade looking to profit from a retracement if one of these additional conditions are met:

  1. The moving average convergence divergence (MACD) has shown divergence from price (for example, if the price has made a new low, but the MACD has not and has turned from a downslope to an upslope).
  2. The average directional index (ADX) has turned in the direction of a possible retracement.

If the above conditions are met, then consider initiating the trade with a stop-loss order just beyond the recent low or high price, depending on whether the trade is a buy trade or sell trade, respectively. The initial profit target can be the nearest identified support/resistance level.