Drawbacks Of Relative Strength Index (RSI)

The overbought & oversold indications of the RSI don’t always give the true forex market picture because the RSI (a non-trend following indicator) and the market trend share an inverse relationship. So whenever the market exhibits a strong trend, the RSI loses its value and vice versa, which leads to inaccurate overbought or oversold market indications based on strong or weak market trends. The RSI is an oscillator and therefore works best in an oscillating market.

Fast Stochastic Oscillator:
Introduced by George Lane, this technical momentum indicator indicates overbought/oversold conditions by pitching a currency pair’s closing price against its price range over a specified time span. It uses two lines: %K (fast line) and %D (slow line) on a scale of 1-100 to represent undervalued/overvalued conditions on a percentage basis. The following formula is used to calculate stochastic oscillator:
%K = 100 * [(C – L14) / (H14 – L14)]
Where, C = Closing Price
L14 = Lowest price for the range of previous 14 trading sessions
H14 = Highest price for the range of previous 14 trading sessions

This indicator is based on the forex market observation that price closes near the peak in an upward moving market, while price tends to close near its floor value in a downtrend market.

For example, a high reading of above 80% means that the closing price is near the peak for a given price range. In a low reading of below 20%, the price tends to close near the floor value for the price range of a specified time period.

The Fast Stochastic Oscillator indicates buy/sell opportunities when the %D (a three-period moving average) is crossed above/below by %K. The two lines are drawn at the 80% and 20% levels and are called “trigger lines,” since movement above 80% and below 20% triggers transaction signals. Stochastic bands are the zones above and below the two lines. Inability of stochastic lines to follow a pair’s price in setting a new high or a new low (divergence) provides buy/sell signals.

Read about the uses of the RSI in forex trading.

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