Interactive Trader

Technical Analysis: Using the RSI

There are so many technical indicators available to the trader today and for some, choosing between them is a nightmare. When you are considering using the RSI as your momentum indicator, for long trades, you would want the indicator to be above 50 on all time frames, and for short trades, you would want it to be below 50 on all time frames. Momentum indicators are best when your strategy involves following the trend.

How does the RSI work?

The RSI measures how many of the set amount of candles close up, or down, and then give you a score between 0 and 100. If for instance, set period is 5 candles and all 5 the previous candles closed higher than they opened, the RSI would give you a score close to 100, when they closed lower than they opened, a score close to zero, and if the market ranged in the same position a score of 50.

The RSI is a momentum oscillator and simply tells who is in control, the bears or the bulls.

There are 3 parts of the RSI you should be aware of:

  1. Above 70 – Overbought
  2. Crossing 50 – Indication that momentum is changing
  3. Below 30 – Oversold

This simply means, when the RSI is above 70 you would generally expect it to fall when it breaks below 70, this would be confirmation the market is changing down.

The same applies to the 30 line, below it, the market is oversold, and you would expect it to rise, when it breaks through 30 you will have confirmation the market is changing up.

When the market crosses the 50 line, it is an indication the momentum is beginning to change in the direction of the break.

Although all of this sounds pretty easy, many rookie traders have blown their accounts using this indicator without understanding it properly.

How to trade with the RSI

When developing a trading strategy you have a couple of options:

  • Following the trend
  • Fading the trend
  • Range Trading

When following the trend:

When the RSI crossed from below 50 to above this is a signal that a bullish trend may be starting.

When the RSI crossed from above 50 to below 50 it is a signal a bearish trend may be starting.

When Fading the trend

When the RSI crosses from above 70 to below 70, it indicates the bulls are losing control of the market and the bears are ready to step in.

When the RSI crosses from below 30 to above, it indicates the bears are losing control of the market and the bulls are ready to step in.

Always look for a confluence of factors

As a trader, you should know there is no way to predict the future. The best we can do is looks for setups with the highest probability of success. Trends can go on for years, and even these strong trend can come to an end in an instant. Use the RSI in conjunction with other indicators such as the MA 200, support and resistance or other analysis methods to develop a high probability strategy and always backtest your strategy before trading it.

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Part Two: Learning to Trade

In our last article, we took a look at some of the terminology understood and used by Forex traders, and now we’re going to provide some application of those terms so you can begin your trading the right way.

You may recall what is perhaps the most important term you can learn — “Pip,” which is the smallest price change that a given exchange rate can make, and the way traders track their wins and losses.

We also mentioned that traders can choose a lot size — standard, mini, or micro — and because of the different lot sizes the monetary value of a pip you win or lose can vary according to the size of your trade and the currency you are trading.

Many traders choose the mini lot size, which uses increments of 10,000. A lot size of 10,000 for the EUR/USD is worth $1.00 per lot, so if you chose to trade 3 lots (or 30,000 in total), each pip is worth $3 in profit or loss. A full size lot, or standard lot, is 100,000 where each pip is worth $10, and a micro lot size is 1,000, where each pip is worth $0.10.

Some currency pairs will have different pip values. Be sure to check with your broker, or consult the software you use to plan your trades for information about currencies and their current pip values

A 5 pip spread for EUR/USD is 1.2530/1.2535

One of the nice things about trading currencies is there is no commissions — but how can that be?. If you look at the quote above, you’ll notice a small difference of pips between the two quoted currencies (in the 4th decimal place); the difference in prices here equals 5 pips.

This 5 pip difference in price is known as the spread, and the spread represents the difference between the ASK and BID is called spread. This spread represents brokerage service costs and replaces transactions fees for Forex traders.The spread is how the broker makes his money and works similarly to the bid/ask in stock trading.

Not all spreads are created equal. The spread differs between brokers and sometimes even the time of day can cause volume to be light and the spread to subsequently increase for some brokers. There are several factors that influence the size of the bid-ask spread, with the most important being currency liquidity. Popular currency pairs are traded with the lowest spreads while rare pairs might have as high as a “dozen pip” spread.

The next factor that can influence the bid/ask spread is the amount of a deal. Middle size Forex trading deals are executed on quotations with standard tight spreads, but extreme deals – including ones that are very small along with ones that are very large – are quoted with larger spreads due to the risks taken by brokers.

During volatile market times, bid-ask spreads are wider than during quiet market conditions. Even the status of a trader can influence the spread as the biggest traders can enjoy personal discounts. It is fortunate that you are trading during a time of high broker competition, which means as brokers attempt to attract customers, their spreads are usually at or near their lowest levels.

As a trader, you should always pay attention to spread management, because good trading can only happen when all of the market conditions are considered. It’s important to realize that because spreads may change at any time, your spread management strategy should remain flexible enough to adjust to any market movement.

To help you understand more about pip spreads, here are the types you will routinely see as you trade the Forex market:

  • Fixed spread – difference between ASK and BID is kept constant and does not depend on market conditions. Fixed spreads are set by dealing companies for automatically traded accounts.
  • Fixed spread with an extension – a certain part of a spread is predetermined and another part may be adjusted by a dealer according to market.

Variable spread – fluctuates in correlation with market conditions. Generally variable spread is low during times of market inactivity (approximately 1-2 pips), but during a volatile market can actually widen to as much as 40-50 pips. This type of spread is closer to real market but brings higher uncertainty to trading and makes the creation of an effective strategy more difficult.

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Part One: Learning to Trade

If you are looking to become an investor in the foreign exchange market — also known as the Forex market —  there are three types of accounts designed for retail investors: standard lot, mini lots and micro lots. Best of all, beginners can get started with a micro account for as little as $50.

However, before you begin your Forex market, take some time to learn a little more about how foreign currency trading works by reviewing some of the most important terms of the Forex market. If you already have some experience trading stocks or options, you should pick up Forex trading very easily.

Here are some of the most common — and important to know — Forex terms.

BASE CURRENCY: The first currency quoted in a currency pair on Forex. For example, for the currency pair USD/GBP, the U.S. Dollar is the base currency. The base currency is also known as the domestic currency or accounting currency.

CROSS CURRENCY PAIR: A pair of currencies traded in Forex that does not include the U.S. dollar. An example of a cross currency pair would be NZD/GBP (the New Zealand Dollar/Great British Pound). When trading these cross currency pair, one currency is traded for another without having to first exchange the currencies into U.S. dollars.

CURRENCY PAIR: The quotation and pricing structure of the currencies traded in the Forex market, in which the value of a currency is determined by its comparison to another currency. These currency pairs are usually written like this:  AUD/USD. The first currency of a currency pair is called the “base currency” (in our example, the Australian dollar), and the second currency is called the “quote currency” (the U.S. dollar in this example). The currency pair indicates how much of the quote currency is needed to purchase one unit of the base currency. (At the time of this article, the AUD/USD = .76, meaning one Australian Dollar is worth 76 U.S. cents.)

PIP: A pip is the smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places (that is, .0001), the smallest change is that of the last decimal point. A common exception is for Japanese yen (JPY) pairs which are quoted to the second decimal point (.01).

QUOTE CURRENCY: As seen above, the second currency quoted in a currency pair in Forex is known as the quote currency. In a direct quote, the quote currency is the foreign currency. In an indirect quote, the quote currency is the domestic currency. This is also known as the “secondary currency” or “counter currency”.

Now that we’ve reviewed basic terminology, let’s look at some of the differences between trading stocks vs. currencies. In currency trading you are always comparing one currency to another so Forex is always quoted in pairs. Whenever you see a trader only talk about one currency — such as saying the euro (EUR) is trading at 1.3224, you may assume that the unsaid currency is the U.S. dollar (USD).

When looking at the quote screen for the first time it may seem confusing at first, however, it’s actually very straightforward. Below is an example of a EUR/USD quote:

EUR/USD = 1.1141

The quote example shows traders how much one euro is worth in US dollars. The “base currency” here is EUR, and the “quote currency” is USD.

When traders buy or sell a currency pair, the action is performed on the base currency.

If a trader is bearish on euros, he could sell EUR/USD. When the pair EUR/USD is sold, the trader is not just selling euros but also buying US dollars simultaneously, which makes up the pair trade.

Let’s say that you sold the EUR/USD at 1.1141. If the EUR/USD falls from that value, we know that the euro is getting weaker and the U.S. dollar is getting stronger. You might have also noticed the quote price has four places to the right of the decimal. Currencies are quoted in pips, where a pip is the unit you use to count your profit or loss. For pairs except for ones including the Japanese Yen (JPY), the fourth spot after the decimal point (at one 100th of a cent) is typically what traders watch to count “pips”.

Every point that place in the quote moves is 1 pip of movement.  For example, if the EUR/USD rises from 1.1141 to 1.1146, the EUR/USD has risen 5 pips.

There’s a lot to learn about Forex trading, and we’ll provide more information for you right here in future articles…

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