Ask the Experts: How do I spot trend reversal using Relative Strength Index?
Posted by Orli Perez in Ask the Experts, tags: oanda, overbought, relative strength index, RSI, technical analysis, trend reversal, undersold
Welcome back to our Ask the Expert series with Oanda’s Scott Boyd and Dean Popplewell. This week’s question comes from our Facebook page:
Okogba Papa Woyin-Emi asked “What are the best ways to spot trend reversal?”
Great question, and not one that can be answered fully in a single post. So we’re going to tackle this important topic in multiple phases, starting with… spotting trend reversal using Relative Strength Index:
Regardless of individual trading strategies, all traders share a common goal – identifying as early as possible, potential trend reversal points. The earlier you can get in on a reversal, the greater the potential for profit. Unfortunately, it is also true that the earlier you act, the greater the chance that what you thought was a trend reversal is really just a fluctuation and once the tend resumes, you may suddenly find yourself on the wrong side of the trend!
To help avoid this scenario, there are several approaches you can take to improve your analysis of the current market trend. Generally speaking, analysis falls into one of two types – fundamental analysis and technical analysis. Fundamental analysis consists of news events such as central bank actions or the latest unemployment figures. The rule of thumb is that when news is seen as a positive sign for a country’s economy, the currency tends to perform better. While the correlation between economic performance and exchange rates is helpful when defining an overall trading strategy, this approach offers little insight into potential reversal points.
This is where technical analysis comes in. Technical analysis involves the use of charts and historical prices in an attempt to determine future prices and over the years, a whole host of technical indicators have been developed. We don’t have room to discuss them all here, but we’ll cover a few our favorite indicators and show you how they can be incorporated into your own studies.
Relative Strength Index
The Relative Strength Index (RSI) calculates the total average losses and gains for a currency pair and uses this information to determine the strength of the latest price in relation to the previous price. A numerical value is determined as part of the RSI calculation and this number is plotted on a chart segmented from 0 to 100 and placed at the bottom of a price chart as illustrated below:
If the RSI value falls in the 30 or under range in the chart, it is considered undersold suggesting that the market could soon start buying the currency pair thereby pushing the rate higher. A reading of 70 or higher on the RSI scale is considered overbought and identifies a potential opportunity to short the currency pair ahead of a falling exchange rate.
In addition to the undersold and overbought designations, traders also look for what are known as centerline cross-overs. When the RSI crosses over and above the center line (50 on the scale), the buyers are winning and upwards momentum is gaining. When the RSI crosses under and below the centerline, the sellers are gaining and the downwards trend is gaining momentum.
For more detailed information on these and other technical indicators, we invite you to check out OANDA’s fxTrade technical analysis tutorial.
We’ll have more on this topic soon, including how to spot trend reversal using Bollinger Bands and different price chart patterns. Have questions for Scott and Dean? Send them to us via Facebook and Twitter. We are excited to see what you come up with.
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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results.
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Be sure to read the full risk disclosure before trading Forex. Please note that Forex trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved before trading. Performance, strategies and charts shown are not necessarily predictive of any particular result. And, as always, past performance is no indication of future results. Investor returns may vary from Trade Leader returns based on slippage, fees, broker spreads, volatility or other market conditions.
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Hi, just want to point out the relative weakness of technical indicators here so that people get to understand how to use technical indicators properly.
Firstly up with RSI, conditions can stay in overbought/oversold conditions for a long time and offer false buy or sell alerts. For example it can cross above the 70 line to indicate oversold and then break down the 70 line to indicate a reversal only to reverse right back up again to hit your stop loss. Even when we go out to daily charts which helps to reduce the number of false signals offered by technical indicators, this problem still persist. Just take a look at the eurusd chart from September to October for example.
A good way of using technical indicators is actually by doing a mix of fundamental analysis and technical analysis. In the world of technical analysis there is a term called a confluence of signals, that is when two different indicators gives the same signal to buy or sell. However as always, technical indicators are lagging indicators, they are not what drives price action, instead it is price action that drives technical indicators.
So what I prefer to do instead is to use fundamental analysis to first determine which direction the market is likely to be moving and then using the technical indicator to determine whether it is the right time to go in or not. For example if the RSI indicates that prices are at overbought levels, and other indicators provides no strong support levels near the entry point offered by the market, then I wouldn’t be buying. But with the given market condition, if I find that there are fundamental reasons to sell, I would quickly jump into it as prices are at its highs and surely there must be a form of resistance nearby to protect our stop loss tightly and thus offering a good risk to reward ratio.
I hope that offers a deeper insight into the proper use of technical indicators, all the best trading to all of you :)
-Iwan