Interested in Oscillators? We will now meet you with another indicator from the Oscillator Family. Behold the mighty Relative Strength Index Indicator a.k.a. the RSI Indicator!
As a classical leading indicator (oscillator), the RSI Indicator gives you the signals before the event has actually occurred on the chart! Isn’t that great? Not quite! And the reason for this is that leading indicators give many many false signals!
Structure of the RSI Indicator
The RSI is a single line indicator. The other important detail in the RSI structure is the three zones it shows. These are the overbought and the oversold area, which sandwich a neutral zone in the middle. As you probably guess, the overbought zone is the top one, and the oversold zone is the lower one.
Relative Strength Index Indicator Signals
There are three basic signals every Forex trader should be able to attain from the Relative Strength Index Indicator:
Overbought RSI Signal
We have an overbought RSI signal when its line is located in the upper (overbought) area of the indicator. When traders identify overbought conditions, they wait for the RSI line to exit the overbought zone downwards. This is the ultimate bearish signal of the RSI, which is supposed to be used for triggering short trades!
Oversold RSI Signal
This is the opposite case of the overbought RSI signal. The indicator is oversold when the RSI line is located in the lower zone. When the RSI shows oversold market, traders start hunting for a bullish exit of the RSI line from the oversold area. When this set of events is present traders usually buy the Forex pair, expecting an increase in the price.
This is how the Overbought RSI and the Oversold RSI work:
Above you see four signals of the RSI indicator – three overbought and one oversold.
- The chart starts with an overbought RSI signal, followed by a sharp price decrease.
- Then comes an oversold signal, since the indicator has entered the oversold zone. The price increases afterwards.
- The RSI indicator increases as well and enters the overbought zone again. The price creates another drop as a result of this.
- The RSI line then enters the overbought zone again, leading to another price drop.
Well, isn’t that a harmony?
RSI Divergence Signal
The Relative Strength Index indicator is another tool, which is likely to give you divergence. There is a bullish divergence between the RSI and price action, when the Forex pair is decreasing and the RSI is increasing. Contrary to that, you identify bearish divergence between the Relative Strength Index and price action when the pair is increasing and the RSI is dropping.
Bearish divergence is usually signalizing upcoming rapid price decreases, while bullish divergence signalizes for potential rapid price jumps.
Above you see a classical example of a bearish RSI divergence. See that the price increases on the image. At the same time, the RSI line decreases. This means we have a Bearish RSI Divergence on the chart, which signals that the price might decrease.
As you see, a sharp down run appears on the chart right after the Divergence Signal.
The bullish RSI Divergence acts the same way, but in the opposite direction.
Trading with the Relative Strength Index
Trading with the Relative Strength Index can be tricky. Since we now discussed the structure and the signals of the indicator, it is time to demonstrate it in action. Below you will see a real trading case, which demonstrates some valid RSI Signals:
Above you see three trading examples with the Relative Strength Index tool om the M30 chart of the USD/JPY Forex pair.
- The first signal comes when the RSI Indicator gives an overbought signal. We sell the Forex pair when the RSI line exits the Overbought zone as shown on the image.
- The second signal comes when the RSI indicator enters the oversold zone. At the same time, a bullish divergence appears between the RSI line and the price action. As a result of this the price of the Forex pair increases. We need to buy the Yen in the moment when the RSI line breaks out of the oversold zone.
- The third trade comes when the RSI line touches the overbought zone for three consecutive times. At the same time, a bearish divergence is created between the RSI line and the price action. We need to sell the USD/JPY in the moment when the RSI indicator exits the overbought zone.
In many of the cases you would not be able to attain three valid RSI signals. The RSI indicator is known to give many false signals on the chart. Therefore you should conform your risk management rules to the success rate you get with the RSI trading indicator.
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