Relative Strength Indicator in FX trading

Good indicators for traders are those which show market movements as they develop in real time. The best indicators however, show the “future” in addition to this. A common problem with moving averages or the MACD indicator for example is that they lag behind the market. Their values can only be calculated accurately once the movement is done, the candle has a closing price for the given time frame. This is the reason the Relative Strength Indicator, or RSI in short is such a powerful tool when it comes to currency trading

Leading indicators and the RSI

Indicators which show market tendencies in real time or a bit behind are called “lagging indicators”. Conversely those which try to show the changes on the chart before they happen are called “leading indicators.”

Leading indicators are based on the assumption that if the instrument becomes oversold, the price must go up, at least for a short time, and when it is overbought then it must drop. This comes from the fact that after a sharp move in any direction traders are trying to realise some of their profits, temporarily easing the pressure of the initial move. Indicators like this can further be categorized as Oscillators, in case they are range bound like the RSI, which also happens to be one of the most widely used indicators.

Relative Strength Index – RSI

The RSI, when used on a chart of a currency pair, measures the relative strength of the instrument compared to itself, rather than to another instrument or index. In order to do so, it compares the magnitude of a recent gain to recent losses, from which it is able to determine whether the asset or FX pair is currently overbought or oversold. The RSI oscillator has a range from 0 to 100, above 70 then the instrument is considered overbought, below 30 and it has dropped more than what was anticipated by the market and is now considered oversold.

The creator of the RSI, Wells Wilder, recommended an RSI period of 14, but many traders use the 9 or 25 period for currency trading. The period can usually be set to any number, but it is important to know that the shorter the time frame, the more volatile and erratic the indicator becomes. In this case the RSI shows false signals in a lot of cases, rendering it useless. In case the selected period is too long the indicator becomes flat like a pancake, and won’t show anything of value. Changing up the measured period of the indicator therefore lets the trader adjust how often the RSI may enter into the oversold or overbought territory.

Another important attribute of the RSI is that it can show a divergence between the recent movement of the instrument and the indicator itself. This occurs when the underlying reaches new highs or lows but the RSI cannot penetrate above or below the previous levels. In these cases the RSI will have a divergence (moving in the opposite direction) compared to the chart, which is a very powerful tool to discover possible reversals of the current trend.

All in all, the RSI can be used to help the currency trader with the following:

  1. The RSI can usually predict the highs and lows of an instrument. If the index is above 70 it might be a new high, and below 30 might be a new low. In case of a bull market the high should be above 80, and in a bear market the low should be below 20
  2. It is possible to draw support and resistance levels on the RSI’s graph itself. This might further help in discovering trend reversals or major levels.
  3. A divergence can occur when the RSI moves in the opposite direction compared to the instrument. This is not necessarily bad, since it can signal the reversal of a trend.

An RSI, combined with a consistent trading strategy and good risk management can make all the difference between average returns and excellent returns. If currency trading is a vehicle to deliver the trader to their goals, then it is certainly recommended to study the potential positive effects of adding the RSI to the strategy.