Forex Market Analysis

15 - RSI - Basics

Typography

In the last section we looked at Moving Average crosses and using Moving Averages to determine the trend. In this section we will move on to a new type of indicator - the Oscillator. Unlike the MA, Oscillators tend to appear below your MT4 chart in a separate window. We're going to take a look at one of the most common oscillators, the Relative Strength Index or RSI:

RSI looks at an instrument's ability to close higher/lower over a given period. When RSI is above 70, a forex currency pair is considered 'overbought' and when it's below 30, it's considered 'oversold'. It's important to note that just because a security is overbought/oversold, does not mean it's going to reverse - Indicators can read overbought/oversold for extended periods of time. A sell signal does not occur until RSI crosses back from overbought/oversold into the 70-30 range:

Let's look at the first buy signal - when RSI crosses back above 30 on the 20th of Jan. Note that the forex pair actually sets a new low (and issues a second signal) before moving higher. The first signal occurs at 1.4182, the new low is over 100 pips lower at 1.4079 - chances are most traders would have been stopped out on this signal.

The second buy signal is better, but there is still significant whip saw before the trader eventually nets 380 pips. This sell signal tells the trader to exit their long and go short - the forex trader then proceeds to make another 422 pips before the next buy/exit signal!

So let's have a look, our hypothetical RSI trader's first trade was a loss of 100 pips, before making 380 and 422 pips on his second and third trades. That's 2 wins out of 3 trades, with a net profit of 702 pips!

But what now? RSI is telling the forex trader to buy even though the currency pair has just broken below the late February lows. The trader could well lose 110 pips on this signal. That would bring their win rate down to a more realistic 50% and net profit to 590 Pips.

What if our trader had ignored buy signals? GBP/USD is in a major down trend after all. Well, we would have had 1 trade, 1 win and net profit of 422 pips. Over such a small sample size it is hard to compare the two, but long term testing shows better performance when trading RSI with the trend.