Forex Trading: Trading: Using the RSI and Stochastics

The Relative Strength Index (RSI) and the Stochastics oscillator are two of the most commonly used indicators on most trading charts. These two popular indicators can be used with a pair of Moving Averages to offer a straightforward, yet effective system for finding beneficial trades.

In this article we'll explore a forex trading Strategy taking advantage of the RSI and the Stochastic oscillator taken together with two Exponential Moving Averages (EMA). While not extremely intricate these indicators, when combined, put the odds of a rewarding forex trade solidly in favor of the trader.

We know the RSI is a momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to establish overbought and oversold conditions of a security. The RSI crosses over a 50% line showing a positive or negative bias. A reading greater than 70 is approaching overbought; while a reading beneath 30 is reaching oversold. Customary setting for the RSI is 14.

The Stochastic oscillator is a time-honored old acquaintance to all technical traders. It is a technical momentum indicator that compares a security's closing price to its price range over a given time frame. The oscillator's sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result. It has a range of 0 to 100. A reading beneath 20 is regarded as oversold; while a reading over 80 is regarded as overbought. Typical setting for the Stochastics oscillator is 14,3,3.

Now, let's combine these two indicators with two Exponential Moving Averages (EMAs). An EMA differs from a Simple Moving Average in that higher weight is given to the more recent data when figuring the average and therefore is considered a more correct, more timely indicator. When all these are pointing in the same direction, we come up with a set-up for a trade where the odds are heavily in the trader's favor.

This is a bit tough to make clear without the assistance of graphics. If you're familiar with how these indicators perform, it should be manageable. You can always visit our site for a complete discussion with charts.

The rules for getting into a trade are: 1) the 5 EMA has to cross over the 10 EMA; 2) the RSI has to cross above or below the 50% line; 3) the Stochastics need to cross up or down as well, but not exceed the 20 or 80 levels. All three have to take place, all at the same time and all pointing in the same direction. It's also a good idea to check the higher timeframes, H4 and D1, to see that you are trading in the direction of the general trend.

When all the indicators line up like this...it's a reasonable indication that you're safe getting into the trade. You could stagger your take profit targets as some signal providers I've seen recommend. Take one-third at 10 pips, another third at 20 or 25 pips and let the final third continue with a trailing stop loss.