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How do I use the Relative Strength Index (RSI) to create a forex trading strategy?

The relative strength index (RSI) is most commonly used to indicate temporary overbought or oversold conditions in a market. An intraday forex trading strategy can be devised to take advantage of indications from the RSI that a market is overextended and therefore likely to retrace.

The RSI is a widely used technical indicator, an oscillator that indicates a market is overbought when the RSI value is over 70 and indicates oversold conditions when RSI readings are under 30. Some traders and analysts prefer to use the more extreme readings of 80 and 20. A weakness of the RSI is that sudden, sharp price movements can cause it to spike repeatedly up or down, and, thus, it is prone to giving false signals. Also, it is not uncommon for price to continue to extend well beyond the point where the RSI first indicates the market as being overbought or oversold. For this reason, a trading strategy using the RSI works best when supplemented with other technical indicators.

The following is an intraday forex trading strategy that employs the RSI and at least one additional confirming indicator:

• Monitor the RSI for readings indicating the market is overbought or oversold.

• Consult other momentum or trend indicators for confirming signs of an impending retracement. For example, if the RSI shows oversold readings, a retracement to the upside is anticipated.

• Only initiate a trade looking to profit from a retracement if one these additional conditions is met:
1. The moving average convergence divergence (MACD) has shown divergence from price (for example, if price has made a new low, but the MACD has not and has turned from a downslope to an upslope), or
2. The average directional index (ADX) has turned in the direction of a possible retracement.

• If the above conditions are met, then initiate the trade with a stop-loss order just beyond the recent low or high price, depending on whether the trade is a buy trade or sell trade, respectively.

• The initial profit target can be the nearest identified support/resistance level.