Relative Strength Index, or RSI, is similar to the stochastic in
that it identifies overbought and oversold conditions in the market. It is also
scaled from 0 to 100. Typically, readings below 30 indicate oversold, while
readings over 70 indicate overbought.
How
to Trade Using RSI
RSI can be used just like the stochastic. We can use it to pick
potential tops and bottoms depending on whether the market is overbought or
oversold.
Below is a 4-hour chart of EUR/USD.
EUR/USD had been dropping the week, falling about 400 pips over
the course of two weeks.
On June 7, it was already trading below the 1.2000 handle.
However, RSI dropped below 30, signalling that there might be no more sellers
left in the market and that the move could be over. Price then reversed and
headed back up over the next couple of weeks.
Determining the Trend using RSI
RSI is a very popular tool because it can also be used to confirm
trend formations. If you think a trend is forming, take a quick look at the RSI
and look at whether it is above or below 50.
If you are looking at a possible uptrend, then make sure the RSI
is above 50. If you are looking at a possible downtrend, then make sure the RSI
is below 50.
In the beginning of the chart above, we can see that a possible
downtrend was forming. To avoid fake outs, we can wait for RSI to cross below
50 to confirm our trend. Sure enough, as RSI passes below 50, it is a good
confirmation that a downtrend has actually formed.
