Using the RSI technical indicator to identify oversold and overbought trading conditions.

May 20 • Forex Trading Articles, Market Commentaries • 602 Views • No Comments on Using the RSI technical indicator to identify oversold and overbought trading conditions.

There are several indicators that help FX traders and traders of many other securities, to identify what are referred to as “oversold”, or “overbought” conditions. The most popular indicators for pinpointing the two extremes of market behaviour, are the RSI and the stochastic oscillator. The stochastic indicator is often referred to as “stochastics”, a reference based on the use of two lines to determine the reading value.

Both the RSI and stochastic indicators have a range of measurement of 0-100 and when placed on charts and various time frames, have areas on the charts which, when the indicator passes into, judgements are made regarding the security being considered oversold, or overbought. For the RSI the areas are considered to be 70 or 30; if the indicator generates a reading above 70 the security is considered overbought, below 30 and the security is considered oversold.

The indicator was originally developed by J. Welles Wilder Jr. and introduced in his 1978 book; New Concepts in Technical Trading Systems. The current popularity of the RSI indicates the popularity of technical trading indicators, before the birth of internet trading. The standard setting of the RSI is 14, representing a value measured over a fourteen day trading period. Analysts and mathematicians such as Welles Wilder, created the indicator to be used on: daily, weekly or monthly charts, although theoretically the arithmetic supporting the indicator’s use isn’t corrupted, when used on lower time frames.

However, many technical analysts will suggest the setting shouldn’t be altered from its standard 14 setting as doing so, whilst also placing it on lower time frames, can generate false readings and cause traders to engage in curve fitting behaviour; whereby they attempt to match the indicator’s movement to prevailing conditions.

The key addition traders and analysts are encouraged to make with regards to the RSI, is to consider including an extra level of 50 onto the time frame. The suggestion is that this extra level of demarcation can be used as a trading prompt to enter trades. The inference is that on approaching and passing the 50 line, in either direction, the security is beginning to develop trending characteristics. For example; if price moves in a bullish manner, to cause the indicator line to pass through the 50 level in an upswing, traders might choose to go long once 50 is reached and then stay in the trade until a reading of 70 is reached, at which time the trade is exited.

Other strategies might involve selling or buying, when the oversold or overbought readings are reached. For example, immediately the 70 reading is reached, traders might short the security. However, this strategy can involve staying in the trade for some time whilst requiring a considerably wider stop, as the extreme, overbought conditions might remain in place, for some time.

Many traders consider combining using the oscillating qualities of the RSI, with other indicators. A combination of the RSI + the MACD momentum indicator, is a long standing popular choice. The MACD measures the relationship between two EMAs, whilst the RSI measures price change in relation to recent price highs and lows. The indicators use different formulas for the calculations and deliver different signals, during certain trading conditions. Traders will often look for the indicators to align, in order to deliver extra confirmation, before they’ll commit to make a trading decision.

In the following example, only the RSI is being used and isolated on a daily time frame, with the setting left as standard at 14. The illustration is used as an example of how the indicator can be used to potentially identify: oversold, overbought and trending conditions. During the month of May 2019, GBP/USD has displayed the text book characteristics outlined in the aforementioned description, clearly illustrating the efficiency of the indicator, when used for the purpose the original creator intended.

It must be noted that the underlining movement in GBP/USD during the month, is primarily related to the issues surrounding Brexit. However, analysing the movement of the security from a technical basis only, using price action also, clearly reveals the potential benefits of using the RSI on a technical analysis basis singularly. Traders should also be mindful of the fact that nearly all indicators repaint; the readings you’ll observe at any given time, don’t necessarily correspond with the hindsight readings you’d experience, at all the dates and times referenced. 

The RSI rose above the 50 level on April 30th, as the bullish price action developed, resulting in the 200 DMA being breached to the upside. The RSI remained above the 50 level, without breaching the 70 line, indicating overbought conditions. On May 8th the reading fell below the 50 level. As a doji candle formed on the previous day, text book bearish price action developed over a series of trading sessions, as a significant sell off ensued, whilst the 200 DMA was breached to the downside.

This sell off continued until May 17th, as price caused the the RSI to fall beneath the 30 level. A significant amount of circa 300 pips, could have been theoretically banked during May 8th to May 17th, by simply following the basic recommendations offered up by many analysts, who testify as to the benefits of using the RSI in technical analysis. And whilst every situation is not as ‘text book’ as the following GPB/USD trade, this example has not been cherry picked. It’s topical, recent and the settings have not been altered, in order to curve fit the current situation. 

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