RSI Forex Simplified: Everything You Need to Know
The RSI indicator is a renowned momentum indicator and is one of the most reliable indicators out there. Traders in the stock market and forex alike use it to identify trend reversals and ride the trend to make a huge profit. Here, we will discuss the RSI forex basics as well as a strategy to give you a better understanding of this potent tool.
- What is the RSI Indicator
- How to Use RSI Indicator
- RSI Indicator Buy and Sell Signals
- RSI Forex Strategy
- Best RSI Trading Strategy Explained
- Best RSI Settings for 1-hour chart
- Best RSI Settings for 4-hour chart
- Pros and cons
What is the RSI Indicator
The relative strength index (RSI) indicator is one of the most widely used indicators in the market. It is used to indicate overbought or oversold conditions in a market. One common use of the RSI indicator in intraday trading is to identify the turning points reversal in the market. It can also be used to find entry signals for both long and short positions.
How to Use RSI Indicator
The RSI indicator is a technical indicator and an oscillator that is used to measure the momentum behind the price movement. When you enable the RSI indicator, you will see the graph under the main chart. This graph has a value between 0 to 100. Any value between 30 to 70 is not important. What is important is when the RSI line goes over 70, indicating an oversold condition, or under 30, indicating an oversold condition. Certain traders wait until the value is above 80 or 20. Below are the default settings for the RSI indicator.
RSI Indicator Buy and Sell Signals
As mentioned before, the middle range of the RSI indicator isn’t that important. We’re interested in the extremes. Most traders would be interested in making a move when the indicator goes above 70 or below 30. When the RSI indicator value goes above 70, it indicates an overbought condition and may indicate a potential trend reversal or pullback. That would be a good time to go short. On the other hand, if the value dips below 30, that is an oversold condition and also may lead to a trend reversal or a pullback and that would be a good time to go long.
RSI Forex Strategy
One drawback of the RSI indicator is the fact that it can produce false positives or fakeouts. There are times when the RSI indicator can go up and down beyond the values mentioned above because of sharp price movements, although a trend reversal is not going to happen. For this reason, the RSI indicator is best used with price action other indicators to confirm an entry or exit point.
Another thing to keep in mind is that just because there is an overbought or oversold condition, it does not mean that there will be a trend reversal. The price may continue to go up even when the RSI indicator shows an overbought condition, or down when there’s an oversold condition. For this reason, your best bet of making the most out of the RSI indicator is to use it alongside other indicators and price action before you commit. We will cover more in depth of the price action entry requirements in the later section of this article.
Alternatively, you need to wait for a price confirmation before making the move. If you are looking to go long, you want to see the price close bullish with the RSI indicator after a period of downtrend. If you want to go short, the price should close bearish with the RSI indicator after a long period of uptrend. We’ll talk about one of the best trading strategies using RSI indicator, divergence, and support/resistance level in the next section.
Best RSI Trading Strategy Explained
Here, we will discuss a specific strategy to help you turn a profit with the RSI indicator. First, you will need to tweak your RSI indicator settings. The default value for its smoothing period is 14. Change that to 8 so that the indicator is much more responsive, which is important when you are looking for overbought or oversold conditions. In addition, change the indicator lines to 80 and 20, instead of 70 and 30.
After you got these settings locked in, it is time to look for the right market. Look for the currency pair that shows the lowest low in the last 50 candles. Consider using a horizontal line to mark the lowest in the last 50 candles so you can see how strong the trend is.
At the same time, you want the RSI value to be 20 or lower when the candle is the lowest in the last 50 candles. When that happens, chances are that a trend reversal is imminent and you want to ride that trend reversal.
But before you do that, remember the false positive from RSI? You don’t want to jump into the market immediately. Instead, wait for a bit until you see a second price (low candle) to close after the one we just saw. The second candle here must be lower than the first one, and the RSI must show a higher value than the first.
Keep in mind that divergence can be spotted by looking at price action trading and indicator movement. Normally, when the price keeps hitting a higher high, then the RSI line should also go up as well. This is a sign that the trend will continue to go upward. The reverse is also the same. If the prices keep hitting a lower low and the RSI line does the same, the downward trend will continue for some time.
For this strategy, we are looking for a divergence between the price action and indicator movement. When you are looking to make an entry, you want to see the prices keep hitting lower lows while the RSI line goes up.
It is worth pointing out that you should jump into a position just because you see a bullish or bearish divergence. This strategy may take a while to develop, so be patient and wait for that second low since it allows you to get into a better trading position.
When that happens, go ahead and look for entry as a trend reversal is coming very soon. Entering the trade is a relatively simple process. You want to wait for the confirmation that a trend reversal actually happened. In this case, you want to wait for the price to head in the direction of the trade and that the candle closes above the first candle that was the lowest in the last 50 candles.
After making an entry, it is time to put a stop loss level to cover your bases in case things go south again. To do this, bump back to 1 to 3 time periods and look for a previous support level. The support level is basically the price floor that pushed the prices back up. That way, if the trend continues to dip down and hit that support level, chances are good that it will bounce right back up.
Finally, you should follow at least a 1 to 3 profit vs. risk level. This ensures that you are maximizing your potential to make the most profit out of your strategy. This means that you are gambling to make 3 times the amount you spent to get into the market. In this case, the 1:3 risk reward ratio would mean that you are spending $50 to make $150.
Now that you’ve made your entry, how do you get out? Simple. You wait until you get triple the money you spend. If you want to stick around for longer, wait until the candle is its highest in the last 50 candles and that the RSI indicator is higher than 80. Wait for the divergence and trend reversal confirmation, then that would be a good exit point.
Best RSI Settings for 1-hour chart
Many intraday traders underestimate the usefulness of the RSI indicator mainly because they fail to understand how its parameters work. The RSI indicator is a reliable tool and even more so for day traders. The current value of the RSI indicator is 14, which is alright. Still, that timeframe may not generate enough signals for day traders. That would be fine if all you get the infrequent but high-quality trades.
Many traders dislike this strategy, and so they opted for a more exciting path by lowering the timeframe and making the indicator more sensitive. As mentioned before, the value is 14. In the strategy we just discussed, we said to change that to 8.
For day traders, you may want to bring that down to 2 to 6. But making the most out of this RSI indicator setting requires experience. Many experts and intermediate day traders use this timeframe since they can adjust the values based on their position.
Best RSI Settings for 4-hour chart
Other than setting your RSI indicator value to somewhere between 2 to 6, and the indicator lines to 80 and 20, there isn’t much you can do. In reality, profit isn’t made by optimizing your settings, especially for the RSI indicator. What is more important is deciding on what strategy and timeframe you are comfortable trading in.
When trying out a new strategy, always start with a demo account. A demo account is a throwaway account with some virtual currency at your disposal. That way, you won’t be putting your capital at risk
Pros and cons
In this segment of the article we will be exploring the pros and cons of utilising the RSI. First of all, the RSI is able to show the strength of the momentum in the trend. This can be very insightful for traders as the other than the volume, the momentum is one of the defining factors of the strength of the trend. Secondly, when used correctly, the RSI is able to capture turning points in the trend. This means that it allows the trader to time the market for excellent entries and exits. Conversely, the RSI is prone to false signals especially when the market is heavily influenced by news. On top ofg that, it may over filter certain good entry points in the market as it deems that there is not enough momentum for the price to be in the zone, even if it is a steady trend overtime.
To find out the profitability of the RSI strategy, we decided to do a back test based on the past 10 trades from 14 Apr 21 on the H4 timeframe. The rules for entry will be the same as what was mentioned above. We will be back testing this throughout 3 types of trading vehicles, namely, EURUSD for forex, AAPL for stocks and BTCUSD for cryptocurrency. For simplicity, we will assume that all trades taken have a risk of 1% of the account.
Definitions: Avg Risk reward ratio= ( Total risk reward ratio of winning trades/ total no. of wins) Profitability (% gain)= (no. of wins* reward)- (no of losses* 1) [ Risk is 1%]
An example of the application of the strategy is as shown:
For the Backtest results, trades with blue and yellow zones indicate an overall win with the blue zone as reward and the yellow zone as the risk taken.
As shown in our backtest, the win rate of this strategy for EURUSD (Forex) is 60%, AAPL (Stocks) is 40% and BTC (Crypto) is 20%
The average risk reward ratio of this strategy for EURUSD (Forex) is 3.46, AAPL (Stocks) is 3.1 and BTC (Crypto) is 2.61.
The profitability of this strategy for EURUSD (Forex) is 16.76, AAPL (Stocks) is 6.4 and BTC (Crypto) is -2.78.
Overall, the RSi produced a set of interesting results, it showed disparity across the trading vehicles and turn out to work the best for forex. This may be due to the RSI being around for a long time since the 20th century and it has been proven by history to work on older trading vehicles. As crypto is still newer to the market, the RSI is unable to perform similarly as it may be outdated for trading crypto, hence the price action does not respect the RSI as nicely as the others.
That is everything you need to get started with the RSI forex indicator. Of course, there are countless forex trading strategies out there that make use of other indicators such as (Read more: ATR Indicator, Stochastic Indicator, MACD Histogram, Bollinger Bands Forex). We recommend you try some of them out with a demo account and see what works for you.