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RSI can be used to know about the following:1. Positive / negative divergence
2. Price movement momentum
3. Overbought / oversold conditions
However, among the three purposes above, the first one is the most often used by the trader, especially because its easiness so that RSI interpretation does not bias from one trader to another trader.
Identifying overbought condition / oversold with RSI is very simple. But it’s not that easy. General rule that applies is the condition overbought when the RSI is cutting line 70 and oversold when the RSI cutting line 30. Some books also recommend 20-80 as OB and OS limit. It’s possible for a particular currency that overbought / oversold limit is on 40-60, depending on the currency. Again, need to be trial and error. However, as guidance, RSI will be more accurate to be used in the market which conditions are stable and efficient. Until now, forex market is the most stable and efficient in term of movement (price is determined by the market that are very liquid). So, a more or less restriction 30-70 still applies here, even though not absolute.
Note the chart below:
In the picture, the area colored yellow is OB and OS area. On that RSI is 70 (top side) and 30 (down side). When the RSI is on such areas, then the price will soon be turned back (marked as red circle in the picture above). How’s the price when the OB and OS occurs, we’ve already learn about it in lesson 2.3. Interesting isn’t it? An indicator that is able to know when prices turn! Thanks to J.W. Wilder for creating this.The Centerline Crossover
As well as the MACD can be used to measure the strength of increase / decrease momentum in price, RSI can also be used to do the same thing. The difference is when MACD crossover occurs at the zero line, on the RSI it occurs on line 50.
How to read the strength of momentum on a price is same as MACD, that’s when RSI crossed centerline (line 50) from the bottom, then uptrend will occur. The value of momentum comparable with the value of the RSI occurred. This also applies vice versa. Let's see the picture below:
Note the circle marked in red. We see that when RSI crossed the centerline from the bottom then the price moves up and vice versa when the RSI line crossed centerline from the top so the price tends to go down. There’re certain situations where the signal is not valid because that’s a false signal on the RSI (which we’ll discuss after this). However, with the centerline crossover, it will help us in determining the condition of buying and selling.False Signal on RSI
Don’t uses the RSI indicator without reading this section first! Why? If you are paying enough attention to the picture presented above, certainly some of you asked, why there are some circumstances where RSI is different from the actual situations?
This is called a false signal. If we see from RSI formula, initially we could know that basically, its movement is very sensitive. It’s a sensitive indicator that lets us have a lot of "suggestions" to Buy / Sell. That the benefits. But that’ll at once become a trouble for us, because with so many suggestions we have, there’ll be more misleading suggestion that might bring big losses.
By many chartist, RSI is not used alone as a main indicator for the nature of its sensitivity. RSI is often used to brace suggestion proposed by other indicators.
Is there any way to eliminate false signal on the RSI, or at least reduce the falsity of the RSI? Of course there is. The simplest way is find the best period in RSI that we want to use. As we know that with the greater period of an indicator then the nature of its sensitivity will be decreased. This also applies to the RSI, so we can use the RSI with the period slightly greater than usual, which are 14. Alternatively, you can use greater period, for example, period 18.
You can see in the picture above how the 18 period RSI (colored blue) looks slower in accommodating movement of the currency than the standard period 14.Which period is suitable? That does depend on you. I usually use period 10 or 14.
Alternatively, there’s another way to decrease the nature of RSI sensitivity. It’s done by refining the RSI using SMA.
In the picture above I’m using SMA period 3 to refine RSI. As seen above, the chart has become smoother, and we just need to pay attention to SMA on the RSI to find out the OB and OS condition on the RSI. In its use (SMA on the RSI), it should be understood not to use the period of greater than 5, because it’ll damage the benefits of the RSI itself (its sensitivity). So, for simplicity, use SMA period of 1-5.Refining the chart is very useful for RSI indicator, because it can often drop on the OB and OS area or crossed centerline for a moment. In such circumstances, SMA will refine the curve so it will become smoother.
