CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
RSI stands for Relative Strength Index and it is one of the most famous technical indicators of them all. It is an oscillator, and this means it is applied in a separate window, typically below the actual current price.
An oscillator main's purpose is to show overbought and oversold levels the market may be in. In an overbought area, short trades are recommended, and in an oversold one, long trades should be taken.
This is the standard interpretation of any oscillator, but it doesn't mean it is the correct one nor that it works all the time. If that would be the case, everyone will make money in the Forex market, which is not the case.
The RSI considers a period or several candles before plotting the current value. The bigger the period, the flatter the resulting RSI line will be.
The standard period offered by all trading platforms is the fourteen period, and this means that the current RSI value is the result of the previous fourteen candles. As usual, the bigger the timeframe, the more powerful the implications are.
It is being said that one between the two (price or the oscillator) is lying, or gives a fake move in the end. As a rule of thumb, traders should always stay with the oscillator and not with the price, for the simple reason that the oscillator considers multiple candles instead of one single candle.
Below there are three ways to trade with the RSI, all of them profitable if used in combination with money management techniques and proper fundamental analysis. These strategies differ based on the trading environment that exists at any one moment of time.
The classical way to trade with the RSI is to trade it in the standard way: sell overbought and buy oversold levels. This is working like magic in one single situation: when markets are ranging.
Therefore, if one can identify a ranging environment, the RSI will do the work in showing profitable trading signals. There are trading theories, like, for example, the Elliott Waves theory that allows forecasting future price movements.
It means that ranges can be forecasted if a correction is expected. If that is the case, using the RSI to sell overbought and buy oversold levels is the right thing to do.
Ranges are expected in low-volatility trading sessions as well. The Asian session is characterized by small ranges that hold incredibly well most of the times.
Therefore, the RSI is a valuable tool to use in the Asian session. The oscillator travels between the 0 and 100 level, and overbought levels are considered levels above the 70 mark, while oversold levels are the ones below 30.
It is not possible for the RSI to have negative values, and most of the times it stays between 30 and 70. The chart below shows the RSI applied on the hourly EURUSD chart and buying and selling with the standard interpretation offers great trading opportunities.
Another way to find ranges and to use the standard RSI interpretation is to trade crosses, not major pairs. A cross is a currency pair that doesn't have the U.S. dollar in it.
Crosses are known as being less volatile than majors. Not all the crosses, that is, but most of them.
A bit earlier in this article, it was mentioned that traders should always stay with the oscillator and not with the actual price. To do that, and to spot fake moves the current price makes, divergences are used.
These divergences between the RSI and current prices can be either bullish or bearish and they are being used to further filter the signals generated by the standard interpretation. The idea is to look for the price and oscillator to move differently when the oscillator is in overbought or oversold area.
A bullish divergence formed on the hourly EURUSD chart above. Price made two consecutive lower lows, while the oscillator didn't confirm the second low.
Therefore, the two diverged, and such a situation is a bullish one. A bearish divergence is similar, the only price is making two higher highs and the oscillator is not confirming the second high.
Another way to trade with the RSI is to look at it as a continuation pattern. The oscillator travels between 70 and 30 most of the times, and the logical thing to do is to split this distance into two equal parts.
As such, the 50 level can be drawn. The image below shows various instances where the 50 level acts as a continuation pattern on the road from 70 to 30 or 30 to 70 the RSI makes most of the times.
Out of the three ways to trade with these oscillators, divergences are the most used as they offer great risk-reward ratios. Such ratios can be obtained by placing a stop loss at the last low or high that is the basis for the divergence and the take profit at the 30 level (in the case of a bearish divergence) or at the 70 level (in the case of a bullish divergence).
However, even divergences won't work one hundred percent of the times. A market can stay in a divergent mode more than a trader can stay solvent.
Again, an oscillator is working in a ranging environment, but when new trend starts and ranges are broken, divergences won't work. There are some other trading tools to be used together with the RSI to further filter the signals.
The main thing when trading with the RSI is to identify a ranging market. If this is possible, then the RSI works like magic.
If not, traders need to adapt and use trend indicators to ride the trend and find proper places to add to a trade. Candlestick techniques are also useful to be used together with the RSI as they are mostly reversal patterns. Therefore, RSI divergences can offer a stronger signal if they are backed by a candlestick reversal pattern.
