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How to use the RSI index in forex trading

ForexTraders | Dec 22, 2009 |

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The relative strength index, or RSI, as it is termed by most traders, is available with just about any forex broker in the business. Open an account, and it is almost certain that you will have it available to you. This is partly because it is very popular, and partly because it is an old and commonplace tool among market practitioners. Naturally, this situation results in both disadvantages and advantages for strategies that depend on this indicator. Our aim in this article is to discuss the RSI in terms of the various ways in which it can be utilized by traders.

RSI is a momentum indicator. The indicator confines prices into a range between 0 and 100, but it is clear that the prices do not move in a range, and so there must be another meaning to the oversold/overbought values shown by the indicator. Indeed, what the RSI tries to measure for us is not a concrete concept of value, but the rather abstract and difficult to quantify phenomenon of trader mood. A price is only overbought or oversold if traders feel it to be so, but that consensus cannot be measured directly by surveying traders due to obvious technical problems. This is where your forex broker comes to the rescue. The RSI is one of the indicators devised to overcome this problem by establishing a connection between trader mood and the price action.

But the problem is that in most market conditions the mood of traders fluctuates so fast that it is almost impossible to define it precisely, rendering any reading of the RSI of very little practical value. If volatility is high, and the price action is strongly directional, efforts to trade the market on the basis of oversold/overbought levels will fail miserably. Traders have discovered over the years that the best conditions for using a momentum indicator are those that exist in ranging markets. In ranging markets prices still oscillate, and traders can still go berserk, but their emotional extremes tend to be confined into the overall range established by the bigger players. The RSI will then be helpful in establishing entry/exit points where we can confidently assess the profit potential of our plans.

No indicator is error-proof, and the RSI is no exception. To learn to trade forex, one must first get acquainted with managing the risks inherent in making decisions, and the RSI is only a part of this paradigm. Being confident does not mean being sure, and being an active trader should not equate to being rash and thoughtless. RSI is a great tool for anyone who would like to define a clear strategy for trading with a simple and easy-to-use indicator, and with just a little effort it may prove to be the basis of highly successful approach to trading in general.