To succeed in the Forex market, traders must be proficient in using technical analysis tools. The RSI is one of the necessary technical indicators. So what is the RSI? What does this indicator mean and how to use it effectively in forex?
All these questions will be answered in the following article.
What is the RSI?
The RSI, which stands for Relative Strength Index, is an important technical analysis tool. The index was created and developed by John Welles Wilder Jr. and was introduced in the book “ New Concepts in Technical Trading Systems” published in 1978. He is an American mechanical engineer turned real estate developer.
The RSI is a relative strength index used to measure price changes over the most recent period. From there, it helps investors identify overbought and oversold markets.
The RSI is displayed as an oscillator - which is a line chart of the movement between two limits measured on a scale of 0 to 100.
The RSI calculation
The RSI is expressed by the following formula:
In which: RS is calculated as the average of the total number of rising periods divided by the average of the total number of declines in a given period.
Calculation period: the last 14 days
When calculating the index, Welles Wilder assumed that buying occurs after a bull market and selling occurs after a long bear market. When the RSI > 70 is considered overbought, while the RSI < 30 is considered oversold. Between 30 and 70 is the neutral zone and the 50 level is no trend in price.
Meaning of RSI in Forex
The RSI is important for the forex market. Based on this indicator, investors will know when to enter and close orders. Here are a few meanings of the RSI when trading Forex:
1. The RSI is zoning overbought and oversold
When the index crosses 70, it is considered overbought. This means that the price has peaked and is in a bearish correction trend.
When the index is below 30, it is considered oversold. This means the price is about to bottom out and tends to correct up again.
2. Predict future price trends
The trend is up when:
- The index crossed the threshold of 50 from bottom to top.
- The index is in the 45 - 55 zone then crossed out the 55 zone.
The trend is down when:
- The index crossed the threshold of 50 in the top-down direction.
- The index is in the 45-55 zone but it dropped below 45.
3. Determine the shape of price divergence and convergence
To determine this trend we connect the top to the top and the bottom to the bottom:
- If these two lines move away from each other, it is a divergence. At this time, the price is trending to reverse from up to down. Investors should stop selling activities, to determine the point to make buy.
- If the two price lines and the RSI move close to each other, they are converging. At this time, the price will reverse from decreasing to increasing. Investors should stop the quick entry and prepare to determine the selling point.
How to use RSI effectively in Forex
It can be said that the RSI is a great market analysis tool for investors. However, to be effective, investors must understand and understand how to use this indicator. Here are some uses of the index that you should know:
1. Use the multi-timeframe combined RSI
Traders execute trades on the H4 timeframe and use the larger D1 frame to identify the trend. The combination of RSI and multi-timeframe will follow these steps:
Step 1: Determine whether the price trend on the large chart D1 has entered the overbought or oversold area.
– If you see on the D1 frame RSI < 30 => too Sold. The market is about to reverse from bearish to bullish => should enter Buy order.
– If seen on D1 frame RSI > 70 => Over Buy. The market is about to reverse from Up to Down => should enter Sell order.
Step 2: Determine the entry point on H4
Wait for the price to enter the oversold area on the H4 frame, then enter a Buy order.
Wait for the price to enter the overbought area on the H4 frame, then enter a Sell order.
Investors watch and wait for the oversold zone on H4 to appear and then enter Buy orders.
2. Use the RSI along with the SMA
Based on the meaning of the overbought and oversold zoning above, we will use the SMA 30 and SMA 100 in combination with the RSI to filter for the best signal.
Accordingly, we will enter the command as follows:
Enter a Buy order when the 30 SMA crosses above the 100 SMA and the RSI is above 50. Exit buy when the 30 SMA crosses below the 100 SMA or when the index falls below 30.
Enter a Sell order when the SMA 30 cuts down to the SMA 100 and the RSI is below 50. Exit when the SMA 30 crosses the SMA 100 or when the index reaches the 70 area.
3. Combine RSI with Bollinger Bands
If the RSI is a momentum indicator, designed to stay ahead of the market and provide a signal for the future, Bollinger Bands are a lagging indicator that lags behind the price.
When combining these two indicators together, it will help to create a clear signal filter, the probability of placing an order and being successful will be higher.
4. Combine with the reversal candlestick pattern
Similar to using the above signals, the RSI will combine with reversal candlestick patterns to place orders. Accordingly, we will wait for the index to enter the overbought or oversold area and the reversal candlestick pattern appears before entering the order.
The above XAU/USD pair has exceeded the overbought area on the D1 frame, and the Evening Star candlestick has reversed => investors execute sell orders.
The XAU/USD pair has the RSI surpassing the oversold zone combined with the Morning Star reversal candle => this is the right time to execute a buy order.
In case the RSI has entered the overbought area 3 times, combined with the Bearish Engulfing reversal candlestick pattern appears, investors should prepare to place sell orders.
5. Divergence trading
When the price trend and the RSI go in two different directions, it will create a divergence. To trade this way, you can refer to our example below:
Example 1: Bullish Divergence
In the picture above, we see that the price of the back bottom of the XAU/USD pair is lower than the previous bottom, the price trend is down but the corresponding RSI is in an up direction. Investors can wait for a bullish market reversal.
Example 2: Bearish Divergence
The XAU/USD pair in the image above is higher than the previous high, the price trend is up but the corresponding RSI is in the down direction. At this point, investors can wait for a bearish market reversal.
Example 3: Hidden bullish divergence
The example above is a hidden bullish divergence where the price makes a later low higher than the previous low but the RSI has a lower bottom lower than the previous low. Investors can wait for the price trend to continue to rise.
Example 4: Hidden Bearish Divergence
The example in the image above is a hidden bearish divergence, the price at the back high is lower than the previous high but the RSI makes a higher high. Investors can wait for the price trend to continue to decline.
So your questions about what is the RSI have been answered in this article. Hope the knowledge about the RSI indicator you will use effectively and combine it with other indicators for more successful trading.
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