Technical analysis is a method of predicting price movements and future market trends by studying charts of past market action and comparing it to now moment. Technical analysis is concerned with what has actually happened in the market and what might happen. It takes into account the price of instruments, and creates charts from that data to use as the primary tool. One major advantage of technical analysis is that experienced analysts can follow many markets and market instruments simultaneously.
There are three main principles in technical analysis that should be covered before taking a precise look at the RSI indicator:
1. Trend is your friend
Technical analysis is used to identify patterns of market behavior that have long been recognised as significant. For many given patterns there is a high probability that they may produce the expected results. Also, there are recognised patterns that repeat themselves on a consistent basis.
2. History repeats itself
Forex chart patterns have been recognised and categorised for over 100 years and the manner in which many patterns are repeated leads to the conclusion that human psychology changes little over time.
3. Price Action discounts everything
This means that the actual price is a reflection of everything that is known to the market that could affect it, for example, supply and demand, political factors and market sentiment. However, the pure technical analyst is only concerned with price movements, not with the reasons for any changes.
One of the indicators that technical analysis is very reliant on is RSI – the Relative Strength Index Indicator. RSI indicator trading has been increasingly popular due to its powerful formula and the possible use of RSI divergence. The positive effects of employing RSI indicators can be evidenced by performance of almost any experienced trader. Take it from our award-winning analyst and professional trader Nenad "Tarantula" Kerkez who has been actively involved in studying and teaching the concepts of RSI indicator.
What to know about RSI before you start using the indicator? The RSI Indicator fundamentals
What is RSI indicator? The RSI measures the ratio of up-moves to down-moves and normalises the calculation so that the index is expressed in a range of 0-100. It has been originally developed by J.Welles Wilder.
If the RSI is 70 or greater, the instrument is assumed to be overbought (a situation in which prices have risen more than market expectations). An RSI of 30 or less is taken as a signal that the instrument may be oversold (a situation in which prices have fallen more than the market expectations). Contrary to many opinions, the RSI is a leading indicator.
The formula for FX RSI indicator takes two equations that are involved in solving the formula. The first component equation obtains the initial Relative Strength (RS) value, which is the ratio of the average UP closes to the average DOWN closes over 'N' periods represented in the following formula:
RS = Average of 'N' day 's closes UP/Average of 'N' day's closes DOWN
The actual RSI value is calculated by indexing the indicator to 100 through the use of the following formula: RSI = 100 - (100 /1 + RS).
To attach the indicator on your MT4 chart simply drag and drop it to the main chart window.
There are many ways to use MT4 RSI indicator and we will explain how to use the RSI in the best possible way.
RSI OBOS Levels
If the RSI is less than 30, it means the market is oversold and the price might eventually increase. Once the reversal is confirmed, a buy trade can be placed.
Conversely, if the RSI is more than 70, it means it's overbought and the price might soon decline. After a confirmation of the reversal, a sell trade can be placed.
The 50 level is the midline that separates the upper (Bullish) and lower (Bearish) territories. In an uptrend, the RSI is usually above 50, while in a downtrend, it is below 50.
RSI Two Period Divergence
Apply a short 5 period RSI (RSI 5) over the longer (default) 14 period RSI (RSI 14) and watch for crossovers.
With the RSI 14, there are times when the market does not reach the oversold or overbought levels before shifting direction. A shorter period RSI is more reactive to recent price changes, so it can show early signs of reversals.
When the RSI 5 crosses above the RSI 14, it means that recent prices are getting higher. A buy signal is generated. 5 vs. 14 cross should happen when 5 period (blue) is oversold (below 30).
When the RSI 5 crosses below and becomes lower than the RSI 14, it means recent prices are declining. This is a sell signal. 5 vs. 14 cross should happen when 5 period (blue) is overbought (above 80).
Experienced traders find that their trading performance greatly benefits from combining RSI trading strategy with Pivot Points.
Drawing RSI trendlines uses the same concepts from our price action trading school. Connect tops and bottoms on RSI chart itself and trade the trendline break. To draw an RSI uptrend line, connect three or more points on the RSI line as it rises. A down trendline is drawn by connecting three or more points on the RSI line as it falls.
The break of an RSI trendline might indicate a potential price continuation or reversal. Have in mind that the break of an RSI trendline usually precedes the break of a trendline on the price chart, thus providing an advance warning and a very early opportunity to trade.
RSI Classic Divergence
The RSI bearish divergence forms when the price forms a higher high, and at the same time the RSI goes down and forms a lower high. You will usually see RSI divergence forming at the top of the bullish market, and is known as a reversal pattern.
Traders expect the reversal when RSI Divergence forms. It is an advance reversal warning as it appears several candlesticks before the uptrend changes its direction and breaks below its support line.
Conversely the RSI bullish divergence will form when the price forms a lower low and the RSI forms a higher low. This is an advance warning sign that the trend direction might change from downtrend to uptrend. RSI divergence is widely used in Forex technical analysis. We prefer using higher timeframes (H4, Daily) for trading RSI divergence.
Using these principles you can get various rsi indicator buy and sell signals. The best RSI indicator is the default one, found on our MT4 Platform.
Conclusion: RSI Forex trading
It is so simple to jump into trading using the Forex RSI indicator that novice traders often begin trading without testing different parameters or educating themselves on the proper interpretation of an indicator because of the desire to grab money quickly!
As a result, the RSI has become one of the most widely misused MT4 indicators. Once understood and correctly applied, the RSI has the ability to indicate whether prices are trending, when a market is overbought or oversold, and the best price to enter or exit a trade. It can also indicate what trading timeframe is most active and provides information in determining key price levels of support and resistance.
The RSI can provide you with technical trend information and also RSI buy and sell signals. It is crucial that you practise the RSI trading strategies on demo account and then apply it to live account. Additionally the RSI strategies can complement any Forex strategy that you have been using.