The RSI and stochastic indicators are both popular when it comes to analysing currency pairs for buy and sell signals. They can be used to spot trends and momentum. Whilst they are good in their own right, they can work even better when combined together which helps to filter out some false signals and time your entry into the market. In this guide I will look at a simple RSI and stochastic strategy that you can use to analyse currency pair charts and find trading signals.
What is the RSI?
The Relative Strength Index (RSI) is a momentum indicator that measures the speed and change of price movements on currency pairs. It provides traders with signals about bullish and bearish price momentum, including overbought and oversold areas where a price reversal may be imminent. You can also use RSI divergence to establish the overall trend direction.
When the RSI indicator is above 70, it may signal that the currency pair is overbought. If the RSI is below 30, it may signal that the currency pair is oversold. However, price can still continue going up or down even in these extreme zones. This is why we combine the RSI and the stochastic along with other technical indicators and price action analysis to time our entry.
What is the stochastic oscillator?
The stochastic oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of periods. The stochastic indicator can range from 0 to 100. Anything above 80 is considered overbought and anything below 20 oversold. The closing price tends to close near the high in an uptrend and near the low in a downtrend. Stochastic divergence can also help to establish the current trend.
A popular way to trade forex with the stochastic indicator is to look for a stochastic crossover. This is where the main line crosses the signals line. If it crosses upwards this signals an uptrend. If it crosses downwards, this is considered a downtrend. The location of the cross relative to the extreme levels can help determine the momentum of the trend. Combine this with the RSI divergence and extreme zones, then we have a solid base for a forex strategy.
How to trade the RSI stochastic strategy?
The RSI and stochastic strategy combines all of the important elements of each indicator including trend direction, momentum and price extremes. This way we can filter false signals by getting extra confirmation on our trades. I always like to keep an eye out for any candlestick patterns along with support and resistance to time my entry.
You can use this RSI and stochastic strategy on any chart timeframe or currency pair. I personally prefer the 1-hour charts and above as they tend to have less noise when compared to the lower chart timeframes. It also means less time spent watching the charts. You can also use multiple timeframe analysis to confirm trades over the short and long-term.
I like to trade major currency pairs such as the EUR/USD and GBP/USD as they usually have lots of liquidity which means we can catch some good market moves and place trades with tight spreads and quick execution speeds. This is especially the case when using an ECN forex brokers such as IC Markets.
Buy signal
- RSI (14) is near to extreme oversold level (30)
- Stochastic is near to extreme oversold area (20)
- Stochastic main line crosses signal line to the upside
- Divergence to the upside on both indicators
- Bullish price action
The USD/JPY 4-hour chart below shows a good RSI and stochastic signal that catches a good uptrend. You can see that the RSI crossover and stochastic crossovers have happened around the extremely oversold areas. Price has bounced from a support level that was previously a resistance level so we know that it has some significance. There is a big green bar followed by a spinning top candlestick pattern which shows indecision in the market. However, the bulls come out on top and we see some good momentum to the upside. We could have placed the stop loss just below the support level which is around 20 pips. The uptrend went on for over 1,000 pips which gives an excellent risk to reward ratio on this particular trade. There were opportunities to enter the uptrend with additional stochastic crossovers and divergence confirming the trend throughout.
Sell signal
- RSI (14) is near to extreme overbought level (70)
- Stochastic is near to extreme overbought area (80)
- Stochastic main line crosses signal line to the downside
- Divergence to the downside on both indicators
- Bearish price action
You can see in the USD/JPY 4-hour chart below that price had recently breached a key support level. This could have been an entry point if you were simply trading breakouts of support and resistance. However, in this RSI and stochastic strategy, we waited for the pullback to enter. The stochastic crossover happened downwards in the extreme overbought zone and the RSI was not far from its extremely overbought zone either. The market was showing indecision with doji bars and the bears won in the end with a shooting star candlestick pattern. A stop loss of 20 pips would have been sufficient on this trade that has a potential of around 840 pips over the course of a few weeks. You can see there was ample opportunity for entries with multiple stochastic crossovers on the way down and divergence throughout the move confirming downwards momentum.
RSI stochastic strategy Pros & Cons
Pros
- Catch some big currency pair trends
- Time your entry and exit accordingly
- Can be used on any currency pair and timeframe
- RSI and stochastic indicators are free to use
Cons
- Takes some practice to get used to
- Requires good money management
- Signals need extra confirmation
- Will still be false signals
RSI vs Stochastic
Both the RSI and Stochastic indicators can spot overbought and oversold markets but they can both be lagging and price does not always turn at these extreme levels. I would personally give the Stochastic indicator the edge simply because it gives entry points when the Stochastic lines crossover. However, RSI divergence can also be a useful tool and they work well when combined together.
Conclusion: does forex trading with the RSI and stochastic strategy work?
Yes, the RSI and stochastic strategy can be very powerful but it does require some initiative of the trade. I wouldn’t blindly take buy or sell signals from either of these indicators without doing some further market analysis. You will also need excellent forex money management and trading discipline. This can be the different between good and bad results, regardless of the forex strategy that you are using.
If you like the look of the stochastic and RSI strategy, you could always give it a try on a demo account to see how it goes. You can get a free forex demo account from most forex brokers. I would always practice any manual or automated forex strategy on demo at first in order to understand how it works and see if it produces the desired results before taking any risks.
Self-confessed Forex Geek spending my days researching and testing everything forex related. I have many years of experience in the forex industry having reviewed thousands of forex robots, brokers, strategies, courses and more. I share my knowledge with you for free to help you learn more about the crazy world of forex trading! Read more about me.
