Every forex trader knows that the best way to win in the market is to trade in the market’s overall direction. This is called trend and momentum trading.
While following the trend may seem easy at first glance, it is more complex than you can imagine and takes practice to master. That’s because market movements are not linear, and you never know for sure when a new trend is starting or when the current one is ending.
Luckily, there are market tools that can help you trade in the market’s overall direction and make money in the process. One of the best tools you can use is the RSI indicator. By mastering the different RSI readings, it is possible to statistically stay in the direction of the trend majority of the time. So, what is the RSI indicator?
Without going too much into its technicalities, RSI stands for Relative Strength Index. In technical analysis, the reading for RSI is used to determine oversold or overbought conditions. The indicator starts from 0-100, with 50 representing a neutral position in the market.
How to interpret the RSI Reading
When using the RSI, readings above 70 indicate that the market is overbought and that a correction is imminent. On the other hand, readings below 30 indicate that the market is oversold. The idea is that when the RSI has a reading of 70-plus, it is time to sell, while when it reads below 30, it is time to buy.
Sounds simple, right? Well, many have used this interpretation and lost money. The RSI can have a reading of 70, and the market keeps going up. Similarly, a trading pair can have an RSI reading below 30, and the market continues trending down for days or weeks.
So how do you avoid losses from such a simplistic look at the market? Well, you need to understand that the RSI tool uses past data and, as such, cannot be used in isolation. You need to combine it with other tools such as volume indicators and have a general awareness of what is happening in the market.
How to correctly trade the RSI
1. Be conscious of the timeframe you are trading
The RSI can be reading 80 on the 1-hour chart and 60 on the weekly chart. This would mean that the trade is overbought in the day and is up for a minor correction, but overall, the market is going up. In such a scenario, if you want to short the market, you have to do so in time for the correction but exit fast before the uptrend resumes. The same applies to oversold markets.
2. Check the volumes
If the RSI tells you that the market is overbought or oversold, you need to confirm it using volume indicators. This can tell you whether a correction is imminent or the trend is only getting stronger as hype or fear intensifies.
If the RSI reading is telling you the market is overbought but buying volumes are on the rise, it would indicate that the market is entering a strong hype cycle and is likely to get even stronger before a correction follows. Similarly, if the RSI is below 30, but selling volumes are on the rise, it could indicate that the selloff is intensifying and is likely to remain so for a while.
3. Be up to date with the news.
As stated above, volumes can tell you whether hype or fear is intensifying. To get an even better picture of what is happening, be up to date with the news. For instance, if the RSI is at 80 and volumes are rising, check if there is positive news that is behind such an increase in volumes.
The RSI is a powerful tool that can help traders stay in the overall direction of the market trend. However, it cannot be used in isolation like all other tools. You need to combine it with other market tools and be up to date with market affairs.