Oscillators are a class of mechanical trading tools that offer indications of when a currency pair is overbought or oversold. A popular oscillator is the Relative Strength Index.
Relative Strength Index
The relative strength index (RSI) is a momentum indicator that measures a currency pair's strength relative to its won recent past performance. As the indicator is front-weighted (more importance is given to the most recent data), it typically provides a better velocity reading than other oscillators. RSI is less affected by sharp movements, and filters out a lot of "noise" in the Forex market. Many traders also use this indicator as a substitute for volume confirmation, since the over-the-counter structure of the FX market does not
allow for real-time volume reporting.
The basic formula for calculating RSI is as follows:
100-[100/ (1+U/D)]
U = average of upward price change
D = average of downward price change
To obtain U (or D), add closing values for the up (down) days and
divide this total by the time period under study.
RSI's levels are between 0 and 100. Most traders use 30 as an oversold condition and 70 and as overbought condition, although some traders may use 20 and 80. When choosing the settings for RSI, traders should typically use the default time period of 14, since that is what the market as whole tends to look at.
There are five different uses for RSI:
Top and Bottoms - Overbought and Oversold conditions are usually signaled at
30 and 70.
Divergences - When a pair makes new highs (lows) but RSI does not, this usually indicates that a reversal in price is coming.
Support and Resistance - RSI may show levels of support and resistance, sometimes more clearly than the price chart itself
Chart Formations - Patterns such as double tops and head and shoulder may be more visible on RSI rather than on the price charts.
Failure Swings - When RSI breaks out (surpasses previous high or low), this may indicate that a breakout in price is coming.
| An Example: |
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RSI was useful in detecting this USD/JPY short after a crossover of the 70 "overbought" level materialized on the daily. Following the clear sell signals, the pair moved down 450 pips over the next 30 days.
