RSI: Historical Trades

Overbought/Oversold

The chart below offers an example of how RSI can be used to determine if a currency pair is overbought/oversold. Readings above 70 give an overbought indication, and readings below 30 give an oversold indication.

Divergence

The chart below shows an example of how RSI divergence could have been utilized in trading.

Assuming a short position near 1.8900 with a stop at 1.9150, a limit near 1.8400 would have been hit before the price reached the support line. This would realistically have been a good place to cover (exit the trade).

ASSIGNMENT: Using the methods described in this lesson, place a trade on your demo account based on the RSI indicator. Reply to this thread telling us about your trade and why you placed it. If you'd like, feel free to upload an image of the chart you were looking at to help convey to the class why you placed the trade. Also, feel free to ask the instructors any questions that you may have regarding usage of RSI and other indicators that have previously been covered.

Lesson - Relative Strength Index (RSI)

Relative Strength Index (RSI)

What is RSI?

RSI is an indicator that falls under the category of oscillators, and it is an extremely simple indicator to use. RSI works well in range-bound markets, but it has limited value in trending or breakout markets. RSI was created by Welles Wilder, who also created ATR, Parabolic SAR and other well-known indicators.

The Concept of Oscillators

Oscillators are chart studies that are designed to show the strength of the current price in relation to the recent price action. As such, they display the short term momentum of the market, giving signals that the bias of the market is shifting before the price actually changes directions.

The principle upon which oscillators are based is that of regression to a mean. Essentially, a large part of a statistical sample should be within a certain number of standard deviations from the mean of the sample, and if the price strays too far from this center, then it will likely revert back to the rest of the sample. In terms of trading, the price should not rise or fall too far in too short a time.

Oscillators are not usually displayed on the same graph as the price itself, but are most often placed at the bottom of the chart to show that the fluctuations do not occur on the same scale as the price movement.

What RSI Does

Like all oscillators, RSI offer indications of when a currency pair is overbought/oversold. RSI essentially calculates the strength of all upward candles (green) against the strength of all downward candles (red) over the course of the specified time frame.

Parameters

When pulling up RSI on a chart, the charting application will prompt you to select how many periods you would like to include in your study. The most commonly number used is 14, and most traders do not alter this default setting. Some traders do use 9 or 25 period RSI's instead of the standard 14. Of course, increasing the number of inputs will decrease the number of signals and increase the reliability of these signals. Decreasing the number of inputs would have the opposite effect.

How to Use RSI in Trading

• Can be used to determine overbought/oversold levels
• Used to spot divergences, which indicate potential weaknesses in trends

Overbought/Oversold

If RSI is above 70, the pair is considered to be overbought. Some traders enter short at this point, but this can be dangerous as the price may still be rising. Enter short when the RSI crosses back under 70, as this may indicate that the momentum has turned. If the RSI is below 30, the pair is considered to be oversold; enter when RSI crosses back above 30. Like most oscillators, RSI works best when the market is range-bound – in other words, when the market is expected to simply gravitate between an upper and lower level. In trending or momentum-driven markets, using the overbought/oversold levels offered by RSI is generally of limited value.

Divergence.

RSI can also be used to signal when a trend is weakening. If a currency pair makes new highs in its price but RSI does not – meaning there is divergence between the price movement and RSI – it may signal that the trend is not strong, and that a reversal may be imminent. If candlestick patterns confirm, a trader can use this as an opportunity to enter a position.

Moving Averages: Historical Trades

The charts below show examples of how moving averages, when confirmed by price action, can signal trading opportunities.

In the above chart we see moving averages applied to the USD/CHF currency pair. Notice the Hammer candlestick pattern that penetrates the 200 moving average (Black Line). This reversal pattern and the fact that it bounces off of the 200 moving average shows that the downside momentum is lost, and signals that a rally may follow.

Here we see a classic candlestick pattern, as only the long wicks breach below the long-term moving average (200-SMA). As it pierces the 200-day SMA on this daily chart for the USD/CHF, we see a subsequent rally of the pair.

ASSIGNMENT: Create moving averages on chart of a currency pair and place a trade based on the moving averages. Reply to this thread telling us what trade you placed and why you placed it. Feel free to upload an image of the chart to this thread.

Using Moving Averages

What is a moving average?

Moving averages simply measure the average price or exchange rate of a currency pair over a specified time frame. For example, if we take the closing prices of the last 10 days, add them together and divide the result by 10, we have created a 10-day simple moving average (SMA).

There are also exponential moving averages (EMAs). They work the same as a simple moving average, except they place greater weight on the more recent closing prices. The mathematics of an exponential moving average are complex, but fortunately most charting packages calculate them automatically and instantaneously.

Parameters. The most commonly used time frames for moving averages are 10, 20, 50, and 200 periods on a daily chart. As always, the longer the time frame, the more reliable the study. However shorter term moving averages will react more quickly to the market's movements and will provide earlier trading signals.

How to Use Moving Averages in Trading

• Enter when a strong trend pulls back to a moving average line
• Enter on a moving average crossover.

Gauge overall trend. Moving averages display a smoothed out line of the overall trend. The longer the term of the moving average, the smoother the line will be. In order to gauge the strength of a trend in a market, plot the 10, 20, 50 and 200 day SMA’s. In an uptrend, the shorter term averages should be above the longer term ones, and the current price should be above the 10 day SMA. A trader’s bias in this case should be to the upside, looking for opportunities to buy when the price moves lower rather than taking a short position.

Confirmation of price action. As always, traders should look at candlestick patterns and other indicators to see what is really going on in the market at the time. The chart above points out the Bullish Engulfing pattern that occurs just as the pair bounces off the 20 day SMA. Hitting the 20 day SMA, in conjunction with the candlestick pattern, suggests a bullish trend. Traders should enter once the Bullish Engulfing candle is cleared.

Crossovers. When a shorter moving average crosses a longer one (i.e. if the 20 day SMA crossed below the 200 day SMA), that is viewed by many as an indication that the pair will move in the direction of the shorter MA (so, in the aforementioned example, it would move down). Historically, moving average crossovers have not been accurate trade indicators, but they do offer insight into the market’s psychology. Accordingly, should the pair move in the opposite direction of the shorter SMA and thus cross it, this should be viewed as an opportunity to enter a position.

Fibonacci Retracements: Historical Trades

Below are two examples of how Fibonacci retracements, when used in conjunction with candlestick patterns, can be useful indicators for suggesting when a trend will reverse itself. Note how Fibonacci retracements work in both bullish (upwards trending) and bearish (downwards trending) markets.

A Look at a Poor Fibonacci Trade

In order to learn how best to use Fibonacci retracements when trading the FX market, it is worth examining examples of traders often use them poorly.

The following example shows how being over eager can cause a trader to enter the market without justification.

In the chart below, see that price comes very close to touching the fib level (by 13 pips) but does not quite break it. While many traders may take that as a positive sign (they may rationalize that the level was so strong that traders did not wait for it to touch the fib level), you ideally want to see the level being breached. The reason for it is because breakout traders may come into the market, thinking that price will go lower, maybe even down to a lower fib level. When the market reverses and starts to go back into the trend, these short traders will now have to eventually cover their trades at a loss. Short traders who need to cover their positions will add to the buying pressure, thereby increasing the probability of your trade going in your favor.

ASSIGNMENT: Using a charting application of your choice, draw Fibonacci retracement lines on charts for the various currency pairs accessible through the trading station. Then, upon analyzing the charts, look for trading opportunities based on Fibonacci retracements. Reply to this thread telling us what trade you placed and why you placed it. In this case, the trade could be an entry order that is waiting for the price to retrace to a given Fib level. Feel free to upload an image of the chart you were looking at as well.

How to Draw Fibonacci Lines

Fibonacci Retracements:

How to Draw Them Drawing Fibonacci lines is easy. It can be broken down into three easy steps:

• Identify the bottom and top of the overall trend. The bottom is referred to as support, and the top is referred to as resistance. While they are subjective, support and resistance levels can easily be determined simply by looking at a chart.

• Using a charting package you are comfortable with, draw Fibonacci lines from the support level to the resistance level. The three lines should appear: one at 38.2% of the difference from the top and the bottom; one at 50%; and another at 61.8%. These are the key Fibonacci levels around which you should look for potential opportunities to enter trades.

• After that, simply look for price action to confirm an opportunity to enter a trade.

Fibonacci Retracements

What are Fibonacci retracements?

• Levels at which the market is expected to retrace to after a strong trend.

Based on mathematical numbers that repeat themselves in all walks of life, Fibonacci retracements attempt to measure the likely points that a currency pair will retrace, or pull back to within a range. The key numbers in FX trading are 38.2%, 50%, and 61.8%.

Consider the following example to see how Fibonacci retracements work:

Suppose an asset is on an uptrend, going from 0 and 1000. After the asset reaches 1,000, how far will it retrace – meaning how far will it fall – before resuming its initial uptrend? We can do this by using the Fibonacci retracement numbers to gauge how deep of a pullback we could expect after the top “boundary” is reached.

So, mathematically, it works like this:

• The 38.2% line. Calculate 38.2% of the size of the significant price move. The size of the significant price move in this case is (1,000) minus the lower boundary (0). In this case, the size of the significant price move is 1,000 pips. .382 x 1000 = 382 pips. It is expected that the asset will retrace 382 points from its peak. Assuming the asset is going up from 0 to 1,000, it would retrace 382 pips from 1,000. 1,000 – 382 = 618. Accordingly, this is a key level to look out for; you may want to buy here (at 618), as it is expected the upward trend will resume after reaching this retracement level.
• The 50.0% line. Same situation; 50% of the significant price move (1,000 pips) is 500. Take that off from top (1,000) since it is an the upward trend. 1,000 – 500 = 500. Look for the upward trend to resume at that point.
• The 61.8% line. 61.8% of the significant price move is 618. 1,000 – 618 = 382. If the asset retraces to this point, it is viewed as an opportunity to buy.

If the asset were trending lower – meaning it had gone from 1,000 to 0 – then you would use the Fibonacci numbers to calculate the retracement regarding how far the price may rise before resuming the downtrend again. You would calculate the Fibonacci retracements in the same manner, except you would draw from the high point of the significant price move to the low point of the move.

Parameters: 38.2%, 50.0%, and 61.8% are the most common Fibonacci Levels. The 38.2% level is considered the least significant of the three major Fibonacci levels. The larger the percentage line (i.e. 61.8%) the greater the likelihood that the price will find support.

Please keep in mind that other retracement levels exist in Fibonacci Studies that are not widely watched by the market. These levels include 21.4% and 78.6% as well as 127.2% and 161.8% extensions. Most charting packages do not even reference these levels and most traders would argue that if the market retraces 100% of a previous move, the original trend is no longer valid. Other Fibonacci studies called fans and arcs are quite mathematically complicated and are similarly ignored by most traders.

Key Concept: Look for Confirmation

• Traders should enter when confirmation - for example key candlestick patterns – emerge at Fibonacci levels. Traders can also seek confirmation from a variety of other indicators, as we will see as the course continues.

Key Candlestick Patterns

The following are key candlestick patterns to look for:

When these patterns appear in a chart, and when they appear at levels that coincide with other indicators – such as Fibonacci retracement levels, or moving averages – they create a potential trading opportunity.

ASSIGNMENT: Identify a currency pair whose chart shows a candlestick formation noted in this lesson on its most recent daily candle. It is VERY IMPORTANT that the candle is closed; one of the most common errors that traders make is analyzing a candle that is still open. Determine whether this is a good entry point or not, based on how close support and resistance lines appear to the current price. If you do find a plausible trade, place an entry or market order to enter a position. If no good opportunities were available, tell us why you decided not to place a trade. If possible, try to focus on a longer time frame, such as a daily chart. You may use current or past situations.

Key Concept: Candlesticks Signal Reversals

· Candlesticks can be used to identify trend reversals in the market So why are candlesticks so important in trading? Simply put, it is because they are the best gauge of what is going on in the market at the present time. Candlesticks give us insight into the emotions of the market participants. Although traders may come and go over time, human emotion remains constant. A certain series of events creates a candlestick pattern, and when we see that pattern we know exactly what has transpired. Ultimately, candlesticks can easily be used to identify potential reversals of trends in the market – especially when used in conjunction with other indicators.