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Three Ways To Use RSI In Forex

J. Welles Wilder’s Relative Strength Index (RSI) measures the strength of the currency pair against its history of price change by comparing the number of days the pair is up in price to the number of days it is down. Values range from 0 to 100. A common use is as a warning of market tops and bottoms, based on Wilder’s idea that overbought and oversold conditions occur after disproportionate moves. If it’s over 70, one might short; if it’s below 30, one might buy. In an earlier article, I described how you can use RSI for divergence trades.

Here are three other ways to use RSI: First is what Wilder called a failure swing. This happens when RSI exceeds a previous extreme (overbought above 70 or oversold below 20), corrects, and then heads for that extreme but fails to achieve it. You would place a trade on the close of the candle that corresponds to the second peak or dip.

Here’s an example from the hourly EURJPY chart. Price and RSI are rising in tandem. RSI becomes overbought, above 70. Both correct. They again rise but the second peak of RSI is lower than the first. You’d sell on the close of the candle that accompanied the lower peak.

If price and RSI were falling the situation is reversed. When the indicator becomes oversold below 30, corrects, and then fails to reach the prior low, you’d buy on the candle close. Confirming the trade with other evidence—for example, support or resistance or candlesticks—is advisable.

A second use of RSI involves support and resistance, not with price, but on the indicator itself. It can help you gauge if a trend is changing.

Here you would watch the indicator to ascertain that it never rises above (in a down trend) or falls below (in an up trend) key levels. Studying past RSI behavior helps you find these levels.

The 15-minute chart of GBP/USD provides an example. Price and RSI are rising. Price then becomes congested and RSI starts to drop. Is this a simple correction or is the trend changing? Examining RSI provides a clue. RSI never drops below 43. This is above the last dip in RSI and far above an oversold reading of 30. On the second dip in price, with the RSI holding above 43, the trader can feel confident this is a correction and buy on the candle close of the second dip. A safer trade would involve waiting until price broke and closed above the congestion top. As always, it’s best to find other evidence to support the trade decision such as price support and resistance levels, candlesticks, or a comparison with other indicators.

A third way to use RSI is when both price and indicator are in an overall trend in a larger time frame, for example, daily. You then watch the 3-hour or 1-hour chart to find an overbought or oversold reading in RSI accompanying a price rally or reaction. When the RSI overbought or oversold condition corrects, you’d place a trade.

Here’s an example with the AUD/USD three-hour chart. Its uptrend began March, 2009. Where’s a good entry point if you want to go long? In the chart below you see a price correction to .8569. RSI drops to 29.55, oversold. On the next candle close of .8655, RSI is 40.56. This is the buy signal. Had you bought you would have made hundreds of pips as prices climbed to .9328 in late October.

The key to this technique is finding a strong trend on a larger time frame and then trading corrections on the smaller time frame. Best results seem to be when you use daily and one-or –three hour charts. As always, look for other evidence to support your decision—staying above a trend line or candle behavior.

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