The RSI or Relative Strength Index is one of the most accepted indicators used in forex charting. Like the Parabolic SAR, it was invented by Welles Wilder, one of the distinguished technical analysts of our age acknowledged for his expertise with fx trading and fx charts. However, it has a very separate function.
The Relative Strength Index is a momentum oscillator. It compares the price gains of a stock or currency pair to its losses and expresses this as a number between zero and 100. A trader can use the resulting number to determine when a market may be overbought or oversold.
When you have the RSI showing on your forex charting system, you can set horizontal lines at the points that you want to use as triggers. Generally, if the RSI is under 30 the market is oversold and heading for a reversal. If over 70, the market is overbought.
Therefore as a rule, traders set their marker indicators on either 30 and 70, 25 and 75 or 20 and 80. When the RSI crosses these indicators they take a signal to buy or sell the currency pair.
Clearly, if you use the weaker signal of 30 and 70 to open a trade you will be getting in on a trend nearer to the beginning with the expectation of making bigger profits, but at the same time you are likely to get more false signals resulting in losing trades. Waiting for the stronger indication of 20/80 will bring you more winning trades but with a little less profit for each trade, other things being equal.
Of course, you should never use only the RSI to determine when to open a trade. While it is a very quick and simple method of identifying new trends, you will always need to confirm by checking against the stochastic or another indicator. It depends on your overall strategy as to whether you prefer to take a bullish or bearish perspective on events.
If you prefer to follow trends rather than watching for reversals, you can use the RSI as a confirmation of a newly forming trend. You would generally identify first signals from another indicator and then check the RSI. If you are expecting an upward trend, you would be looking for an RSI above 50. This tells you that the recent price gains are higher than the recent price falls, so you have a bullish signal. A downtrend would be confirmed by an RSI below 50.
Like many indicators the Relative Strength Indicator depends on the results of price movements in the more recent past. It will be more or less accurate depending on the number of time periods that are used. in several charting packages you can change this. The lowest that most traders would go would be 14 periods. If you increase it, you will get a more accurate indicator but the latest trend will not be as easily identifiable so soon. So just like when you set the marker lines for the RSI on your forex charting, you have to choose between more wins and lower profits per successful trade, or fewer winning trades but higher profits on each one.
Source by James Roshwood