The foreign exchange market is known as the most critical driver of the British economy. Given its size and liquidity, it is not surprising that the forex market is also one of the most popular markets for traders worldwide.
One of the most popular technical indicators for forex traders is the Relative Strength Index (RSI). Developed by J. Welles Wilder in 1978, RSI is a momentum oscillator that measures the speed and change of price movements. An RSI indicator ranges from 0 to 100, with readings below 30 indicating oversold conditions and above 70 indicating overbought conditions.
Why do traders use RSI indicators?
There are several strategic reasons why traders in the UK use RSI indicators
Identifying potential market reversals
When applied to the GBP/USD currency pair, we can see that traders can use the RSI indicator to identify potential reversals in the market. For example, in early 2020, when the COVID-19 pandemic first started to hit global markets, we can see that the RSI indicator was trending downward as the GBP/USD pair declined in value. However, we can see that the RSI indicator began to approach oversold levels during this period, suggesting that a potential reversal could be on the horizon.
Indeed, as fears about COVID-19 subsided and markets stabilised, we can see that the GBP/USD reversed course and began to trend upwards. Using the RSI indicator, traders may have used this information to time their entry into long positions at opportune moments or short exit positions before potentially significant reversals occurred.
Gauge the strength of a trend
In addition to identifying potential market reversals, traders may also value using the RSI indicator to measure how strong a trend is. For example, we can see that when applied to the GBP/USD currency pair during periods of high market volatility and uncertainty, the RSI indicator may stay closer to the 70 levels, suggesting that the trend is still relatively strong.
On the other hand, if we see that during such periods the RSI indicator begins to approach or fall below 50, this could indicate that the trend may be weakening or reversing.
Time entry and exit points in the forex market
Traders looking to use this information in their trading decisions may value using the RSIindicator to time entry into long positions or short exit positions at opportune moments. In addition, by noting how close various RSI readings are to these levels (50 and 70), traders may be able to identify potential reversal zones in the market.
Along with potentially being used to time entry into long positions, traders may also value using the RSI indicator as a confirmation tool for trend-trading strategies. For example, when applied to a currency pair like GBP/USD that is trending strongly upwards or downwards, we can see that overbought and oversold conditions are clearly defined by the RSI indicator readings of 70 and 30, respectively.
Suppose traders notice that other technical indicators used in their trading strategy suggest that it is time to enter a short or long position. They may also want to note whether the RSI indicator agrees with these signals by looking for overbought or oversold conditions.
Generate buy and sell signals
Finally, some traders may find it helpful to use the RSI indicator to generate outright buy and sell signals. For example, a trader may choose to enter a long position when the RSI indicator moves above 50 from below or enter a short position when the RSI indicator falls below 50 from above.
Alternatively, a trader could wait for the RSI indicator to move above 70 or below 30 before taking a position. These readings indicate extreme overbought or oversold conditions in the market that are likely to reverse soon.
While there are many ways in which traders can use the RSI indicator, these are just a few examples of how traders may use it to identify potential market reversals and confirm trends. Whether you’re a long-term trend trader or looking for quick opportunities, the RSI indicator is essential to help traders in their trading decisions. New traders are advised to contact a reputable and experienced online broker such as Saxo capital markets before using RSI indicators in trading