Developed by the technical analysis pioneer, J. Welles Wilder, the Relative Strength Index is one of the most powerful and precise technical indicators. It is useful both in generating overbought-oversold signals, and in showing trend power. In this article you will learn how to trade FOREX with the Relative Strength Index.
The Relative Strength Index is calculated through comparing the gains and losses in a stock or currency pair, and identifying periods in which the security is overbought or oversold. Overbought periods indicate that the price is too high and therefore a bearish retracement is expected. Oversold periods indicate that price is too low and therefore a bullish retracement is expected. The Relative Strength Index oscillates in values from 0 to 100, when the level of 80 and above is the overbought level, and 20 and below is the oversold level.
Trading overbought and oversold levels is done when these levels are crossed. A cross of the overbought (80) level from above indicate a bearish signal, and a cross of the oversold (20) level from below is a bullish signal. When trading, it is recommended to place the stop loss above the upswing (for short trades) or below the downswing (for long trades). This stop loss strategy minimizes the risk and allows a great risk:reward ratio.
Another trading strategy that involves the Relative Strength Index is a trend-following one. It is easier to trade and gives more signals, but its signals are weaker and win rate is lower. For trend-following traders, it will be a powerful trading signal. The main basis of this system is a cross of the middle line. When the RSI crosses the 50 level from below, a long signal is issued. When the RSI crosses the 50 level from above, a short signal is issued. When trading this method, the trader is always on the market, either long or short. The stop loss mechanism presented earlier is not useful anymore, as the trades are not reversal trades but trend-following trades, and upswings and downswings are very far from entry price. This trading method is profitable mainly in trending markets and generally weak in ranging markets.
In conclusion, the Relative Strength Index is a powerful indicator in any trader’s arsenal. Whether you are a trend-follower or a reversal trader, you will find its signals highly insightful and profitable. It is one indicator that is definitely worth its reputation.