Relative Strength Index (RSI) is a commonly used tool when trading the financial markets, and a relatively successful one at that. The RSI is commonly used when evaluating trends in the markets as well as testing for price action in order to make profitable trades.
When looking at analyst picks or various other market commentaries, it is not uncommon to see the RSI shown in pictures, or being discussed. The reason behind this is that the RSI is a very simple tool to use, with a basic line and 2 key points. The RSI has a scale of 0-100; though it never touches the ends of this scale.
As we can see from above, the RSI generally always moves between the 30 and 70 mark on the chart. Each of these points represents a key point. The 30 mark on the RSI graph represents the point where the market is oversold, while the 70 mark represents the overbought mark. Traders generally pay close attention to these points as they believe that when the market touches these areas, it is time to take action and go in the opposite direction. As the market is self-fulfilling and uses the RSI heavily, it will generally pull back upon touching these points.
When looking to trade RSI, traders will look to enter the market when the currency moves to the 70 or 30 mark. This signals that the currency is overbought at 70 or oversold at 30. Generally, traders will look to take advantage of this in trending marks. The reason I say trend is that in periods of high volatility, traders can get caught out, as markets will break through the RSI but not necessarily fall back. This is referred to as a fake break out on the RSI. These sudden movements can be attributed to fundamental or sudden shocks in the market place.
As we can see at certain points after crashing through on the EURUSD chart, the pair has managed to pull back after breaking through or touching the 70 point. As we can see, trending markets have forced the RSI up before, and then continued to rise. So from this, we can gather that yes the RSI is a good tool to use for markets. But it also requires a very tight degree of risk control. Many traders get caught out on the RSI because they tend to use open orders, and this can lead to massive losses as traders try and ride out the markets. In order to trade with RSI though, tight stop losses come into play in the markets and must be rigidly followed so as not to get trapped in a trending market which defies RSI.
What we have seen so far is that the RSI is an effective trading tool that is useful for a variety of traders, from the experienced to the novice. However, it still retains an element of risk that all traders should be aware about and should actively manage in order to not get burnt. If you play by these rules, you can create some very effective trading strategies and use one of the most successful indicators there is.
Written by Alex Gurr, Currency Analyst from Blackwell GlobalBlackwell Global