Trading CFDs carries considerable risk of capital loss. CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you can afford to take the high risk of losing your money.
Relative Strength Index (RSI) is a technical indicator that belongs to the family of oscillators. Oscillating technical indicators usually bounce within a fixed value and used to indicate the general directional movement of price.
A technical analyst named J. Welles Wilder introduced the Relative Strength Index to financial market enthusiasts in his 1978 book, New Concepts in Technical Trading Systems. Since then, as the popularity of short-term trading grew in the last few decades, the popularity of the indicator ascended among day traders as well.
Before moving on to applying the Relative Strength Index indicator in trading, you should know a few things about how you should interpret the indicator values. Because, unless you have a clear idea how the indicator works, you may not be able to fully grasp the relevance of the indicator readings in live market conditions.
When J. Welles Wilder introduced the RSI, he calculated the value based on a 14-day timeframe. However, as a day trader, you can apply the Relative Strength Index indicator on shorter time frames, such as 14 period 5-minute or 14 period 15-minute timeframe, and it would offer the same effectiveness on an Intraday chart.
Furthermore, you should note that like most oscillators, the Relative Strength Index is also measured on a scale from 0 to 100, where high and low levels are marked by the 70 and 30 levels, respectively.
When the RSI reading goes above the 70 level, it indicates that the asset price is likely overbought. On the other hand, when the RSI reading goes below the 30 level, it suggests that the market might be oversold.
During times of extreme market volatility, such as after a major news release, the Relative Strength Index readings often go above 80, or even 90, as well as below 20 and 10. However, such market conditions are rare and indicate strong momentum. The good news is that, if you find the Relative Strength Index values at such extreme reading, you can be pretty sure that the market is about to start a corrective move soon and prepare for the imminent retracement.
When using the Relative Strength Index indicator, most beginner traders mistakenly place their market orders as soon as the indicator reading goes above 70 or 30. As we discussed earlier, the market can continue to trend, and the Relative Strength Index value can move to as high as 90 or 10 during times of strong bullish or bearish momentum, respectively.
Hence, if you just place your sell order when Relative Strength Index reading is above 70, or place your buy order when the Relative Strength Index reading is below 30, you are risking a significant drawdown before market may turn in your favor.
Another problem with this blind approach is you would need a massive stop loss to avoid being stopped out, which means your risk to reward ratio would be pretty awful.
However, professional traders use the Relative Strength Index indicator differently. Their secret is that they combine the Relative Strength Index signals with other market entry confirmation to pinpoint exactly when and where to get into the market, which means they can set a tight stop loss and get away with a large risk to reward ratio on their trades.
Figure 1: Combining Simple Candlestick Patterns with Relative Strength Index Overbought and Oversold Market Conditions
In figure 1, you can see that we have identified two trades on the GBPUSD hourly chart. In the first trade, the Relative Strength Index indicator reading went above 70 and indicated that the market is likely in an overbought condition. However, instead of merely placing a SELL market order, you should wait for a bearish candlestick pattern confirmation. As soon as the market formed an engulfing bearish outside bar, you should place a pending SELL stop order below the low of the candlestick pattern.
This way, you would enter the market at the right time when the bearish momentum is likely to pick up and can get away with a tight stop loss order.
Similarly, in the second trade, first, the Relative Strength Index indicator signaled an oversold market condition. At that point, the market formed a Three White Soldiers candlestick pattern that confirmed the bullish retracement. If you have placed a BUY stop order just above the high of the Three White Soldiers pattern, you could easily enter the market at the right moment, when the bullish momentum picked up.
Besides using overbought and oversold market conditions, professional traders also use another trick to trade using the Relative Strength Index indicator, which is divergence.
When the Relative Strength Index makes a higher low, but the price makes a lower low, and vice-versa, as the indicator value and the price contradict each other, it is considered a divergence in the market.
Figure 2: Trade Using Relative Strength Index Divergence
In figure 2, the GBPUSD hourly chart offers a perfect example of a divergence. However, instead of blindly entering the market during a divergence, you should once again wait for confirmation in terms of a candlestick pattern. On this instance, the GBPUSD formed a Bullish Harami pattern as soon as the divergence appeared on the chart, and placing a BUY order above the high of this pattern would have yielded some easy pips.
One of the best features of the Relative Strength Index is that the value of the indicator can indicate temporary market conditions, such as when the price of the asset becomes overbought or oversold. As a result, traders can use the Relative Strength Index indicator to prepare for a potential reversal of the prevailing trend and fine-tune their market entry point with precision.
However, as we discussed, you should always wait for a market entry confirmation to place your order. Here, we offered few examples using some common candlestick patterns, but you can also use technical indicators such as moving average crossover, or the Stochastic indicator reversal confirmation to enter the market.