Using the Relative Strength Index when trading CFDs

  • By Harrison Cole

  • November 16, 2018
  • 1:33 am BST

There are countless CFD traders who rely on the Relative Strength Index (RSI) to help guide their trading decisions. The RSI is a technical indicator that works by comparing recent gains and losses in a market. Traders at all levels use it to monitor price action, identify momentum and work out whether a particular asset is overbought or oversold. The RSI can work in any market and is highly popular, but like any other technical indicator, it has its uses and its limitations.

Is the RSI the best technical indicator?

There are plenty of traders who consider the RSI to be the single best indicator for certain types of trading, and those who rely heavily on monitoring short-term price movement as part of their trading strategy would never work without it. However, it is always dangerous to rely on a technical indicator in isolation. The RSI is best for use in combination with other indicators and alongside fundamental analysis to ensure the best trading results.

Who uses the RSI?

The concept behind the RSI has been part of the world of trading since Welles Wilder originally developed it back in the 1970s. It has only become more prominent in the digital age, as it is accessible through most online trading platforms. CFD traders who are trading in any instrument will find uses for the RSI. The tool is popular with swing traders, who use it alongside other tools such as a point and figure chart or the MACD.  Momentum traders extensively use it in conjunction with the Average Directional Index and Rate of Change indicators.

How do you use the RSI in CFD trading?

The RSI is an oscillator with a signal that ranges between 0 and 100. Most traders consider the values of 30 and 70 to be of particular significance. Anything below 30 is generally a sign that an asset is oversold, while a signal above 70 indicates that an asset is overbought.

Many traders will not, however, automatically enter or exit trades based purely on the presence of an under-30 or over-70 RSI signal unless it has support from data from other sources. If, however, the RSI continues to rise to a level of 84 or more, then it indicates a strongly overbought market, and you will tend to see a lot of traders sell a long position or enter a short position at this point. Similarly, a fall to under 15 on the RSI is a strong indication of an oversold asset, and this is where you would expect to see many CFD traders entering a long position or exiting a short position.

As with any technical indicator, traders should look at the RSI as a guide to price action and set up a trading strategy that meets their needs and suits their level of risk. They should also remember that all indicators are fallible, and it is possible for the RSI to give false signals at times.

The RSI and divergence

Most traders rely on the RSI as a strong indicator of when positions are overbought or oversold, and it certainly tends to be a fairly reliable indicator of these conditions. However, it is vital to remember that there are points of divergence embedded in any RSI tool. This happens when there is disagreement between the price and the indicator, and most traders regard it as a very important piece of data to pay attention to.

Divergence occurs when an asset hits a new high or low in price but the RSI does not. The first situation is a sign of bearish divergence and is often a sell signal for experienced traders. Conversely, if a price hits a new low but the RSI does not, then this is a sign of bullish divergence, and many traders may see it as a buy signal.

RSI divergence is not unusual at the top of a bullish market, and when this happens, experienced traders will be on the lookout for a possible reversal. While divergence is certainly a sign that traders should be aware of a potential reversal, there are, of course, no guarantees. Traders should always remember that divergence is most useful as a sign of an imminent reversal in trending markets. When markets are ranging and price swings are regular, monitoring divergence is not quite as useful.

What other technical indicators work well with the RSI?

Traders who spend any time learning about technical analysis soon become aware of how important it is to draw data from multiple sources to maximise their chances of making successful trades on a consistent basis. However, it is important to strike a balance when combining different indicators. Too many can over-complicate your data set and lead to some level of redundancy. It is wise to consider combining the RSI with any of these indicators:

  • The Average Directional Index
  • A moving average indicator
  • A volume indicator

The RSI is basically a momentum indicator, so a similar indicator such as the Average Directional Index can confirm the data that it is showing. Combining RSI data with a moving average indicator such as MACD or Bollinger Bands is a strategy used by some traders to help monitor trends and reversals. A volume indicator such as On Balance Volume (OBV) can also work with the RSI, as it measures both volume and price and can provide further data on price action. This can be very useful to traders trying to identify momentum.

Overall, the RSI is a helpful indicator to add to your trading toolkit. Just remember that it can sometimes give false signals, especially when there is sudden and significant price action, so make it a habit to always confirm data from the RSI with other indicators.