Using the RSI for better CFD Trading
As with the MACD, there are countless CFD traders out there who rely on a momentum indicator such as the RSI to guide their trading decisions.
The main aim of the RSI (Relative Strength Index) is to calculate the relative changes that occur between the higher and lower prices of a particular underlying asset. The index warns traders when the market has entered an ‘overbought’ or ‘oversold’ region and thus when a trend change might be on the cards.
As such the RSI, like the MACD, is an oscillator with a signal that oscillates between 0 and 100. The values of 30 and 70 are considered to be of particular relevance, because below and above them are located the oversold and overbought regions.
Most traders, however, wait for further confirmation before they would enter or exit a trade on the basis of a 30/70 RSI signal. When the RSI breaks through the 84 level, this is interpreted as a very strongly overbought market and this is where CFD traders are advised to either sell their long positions or enter short positions.
If the index breaks below 15, this is considered to be a very strong indication of an oversold market and hence a good entry point to exit short trades or to enter long CFD trades.
To filter out noise, the RSI is often charted with a 9-period Moving Average. Fig. 11.15(a) below shows a typical RSI for the NZD/USD.
At point A the RSI indicated a heavily oversold market. This corresponded to point B on the NZD/USD price chart, which proved to be an excellent entry point for a long trade – or an equally good exit point for a previously entered short trade.
What is important to notice here is that just before point A, the RSI in fact gave an incorrect signal (to the left of point A). An astute trade, who used the RSI in combination with the 9-period moving average, would have waited for point A, where the buy signal was confirmed both by the RSI and the moving average.
In the next chart buy and sell signals are indicated on the same chart.
At point A the RSI starts dropping down from an overbought position. This corresponds with point A on the price chart, which proved to be a great point for either entering a short trade or exciting a long one.
At point B the RSI starts rising after entering an oversold region. This corresponds with point B on the price chart, where the price crossing through the moving average confirmed that an up-trend was developing. Once again this proved to be an excellent entry point for a long trade or exiting the short trade entered into at point A.
As with the MACD and other momentum indicators, the RSI performs best when it is used in partnership with another indicator such as the moving average. By using such a combination of indicators the trader is better able to filter out false signals and market noise.