The relative strength index, or RSI, is a commonly-used indicator for spotting new trends in the price of a currency pair. By using the relative strength index, a trader can keep close tabs on the relative strength of a market movement, up or down.
Using RSI as a momentum indicator
In general, the Relative Strength Index shows us when the market is overbought or oversold. When the RSI reads 70, the market is said to be overbought, and a correction is in store. When the RSI falls below 30, the market is said to be oversold, and a move to the upside should be expected.
The chart below showcases how the RSI works as a momentum indicator:
As you can see, when the relative strength index fell below 30, the price of the currency pair rose. When the relative strength index rose above 70, the currency pair dropped.
Some traders also modify this trading strategy to improve their signals. For example, you might choose to deem 80 and 20 as overbought and oversold. The RSI is significantly less likely to touch 80 or 20 as it is 70 or 30, so by changing your strategy you can filter out the signals that prove to be incorrect. Of course, the RSI can always be confirmed with another indicator, chart pattern, or candlestick pattern.
RSI-based trend spotting
The RSI trended through the midpoint of 50, and the rally continued to follow the RSI. The midpoint at 50 is a critical level. If the RSI fails to break 50, the momentum of a currency pair often stalls out. Some traders use the 50 reading to mark their exit points for high probability trades.
Look at the chart below:
As you can see, the RSI fell below 30, indicating a buy. At 50, the trader decided to take his or her profit on a quick gain, and reduce the risk of a market reversal back to a 30 reading on the RSI. The trader would lose out on the upside here.
However, the next short readings turn out to be false. A trader who sells the currency pair short at 70 would guard profits by exiting at the 50 reading. Just out of viewpoint of the chart, the RSI hits 50 before reversing back higher, a move that would leave traders who shorted the pair to hold heavy losses. Certainly, you could buy at 30 and sell short at 70 every time, but taking profits at 50 allows for much better win-to-loss ratios.
This concept is part of our guide on risk management, so we’ll get there later. For now, we need to keep working through the list of popular indicators. The next indicator on our list is Bollinger Bands.
Proceed to the next tutorial.
