Both the moving average convergence divergence (MACD) and the relative strength index (RSI) rank among the most popular momentum indicators used in forex trading. When used in combination with other technical indicators, both MACD and RSI can offer value in validating trade opportunities and timing trades to optimize your risk management practices.
While they represent a similar approach to evaluating forex trades, the functions of both MACD and RSI are distinct, which makes them useful indicators to combine in trade evaluation. Here’s a look at how to use MACD and RSI as part of your trade analysis.
The Basics of MACD
MACD is a momentum indicator that illustrates the relationship between the 26-day and 12-day exponential moving averages for a forex currency pair.
This relationship is presented on a histogram that offers an easy visual representation of both the strength of a forex price trend as well as signals that may indicate a change in momentum. On the CHF/JPY chart below, the gaps between the 26-day EMA (the blue line) and the signal line (the red line) correlate to the momentum of the price movement. The larger the gap between these lines, the stronger the trend in either direction.
When those lines converge and then cross over one another, it can indicate a shift in momentum that traders may use to time their exit from a position or to plan a new position that aims to capitalize on this opportunity. In the CHF chart below, two such crossovers coincide with changes in price movement for the currency pair.
The Basics of RSI
Relative strength index is a 100-point scale that depicts the momentum of the price movements for a given forex currency pair. This simple chart is divided into three sections to clearly identify overbought or oversold conditions based on those momentum swings.
While RSI also measures momentum, it reflects this momentum through a different analytic approach. RSI can identify buying opportunities by pinpointing trade opportunities where conditions of a currency pair are either overbought or oversold. In situations where conditions are overbought, RSI suggests that the price may be inflated and primed to decline.
In oversold conditions, RSI suggests that traders may have overreacted and have now created value by depressing price and demand for a currency pair. The functionality of RSI is evident in the GBP/USD chart below, where a dive into oversold conditions—below the purple range on the RSI graph—leads to a quick price increase for the currency pair.
Because these momentum indicators evaluate trade opportunities through different methods, they can work well together to validate the signals each one provides, giving traders more confidence when both indicators agree on a potential buy opportunity.
Advantages of Using RSI
Relative strength index has become a widely used indicator in forex for a simple reason: It makes life easier for traders looking for profit opportunities.
When used properly, RSI on its own delivers a number of important benefits, including:
- A simple, easy-to-read design. Unlike other indicators and chart patterns, even a beginner can instantly use RSI to identify overbought and oversold conditions.
- It helps track the speed of momentum—not just movement. Velocity is important when looking to capitalize on forex price movement. A trending price is one thing, but it doesn’t mean that price movement will continue for any measure of time. RSI can help you gauge the durability of that movement based on the current momentum.
- You can use RSI to open and close positions. While RSI offers value in identifying profit opportunities, it can also be used to time your exit from a position, thereby maximizing your profits.
Disadvantages of Using RSI
No forex indicator is perfect. While RSI’s value is well-established, and many forex traders will swear by its value in a larger trading strategy, it’s important to understand the limits of this indicator before you over-rely on its insights.
These potential disadvantages include:
- A lack of consistent signals. While RSI is very useful at identifying overbought or oversold conditions, many forex pairs spend the majority of their time in a range where no strong insights are offered by RSI. In these instances, RSI is more or less useless—and traders must look elsewhere to find good trading opportunities.
- Its signals can lead to false starts. Even when overbought or oversold conditions develop, this doesn’t always lead to forex pairs correcting right away. Conditions can remain on the extremes for a long time, which can frustrate traders looking for short-term trading windows.
- Strong momentum can render RSI irrelevant. When strong momentum for a forex pair develops, other indicators are likely to take precedence over RSI in your decision-making process.
Best Practices for Using MACD and RSI Together
As you incorporate MACD and RSI into your trading strategy, you will likely identify your own set of preferences when it comes to when and how you apply these indicators to your trade analysis. In general, though, you can maximize the value of MACD and RSI through the following best practices:
Combine MACD and RSI to Confirm Price Momentum
The simplest application of these indicators can offer a lot of insight and clarity when it comes to price momentum. If one indicator signals momentum in a certain direction, check the other indicator to see whether it agrees. If their views are split, you may struggle to reach a conclusion that gives you enough confidence to open a position. When both agree, though, traders may feel more confident in taking action.
In the NZD/USD chart below, RSI and MACD both signal momentum shifts in close proximity to one another. In both cases, the RSI slightly leads the MACD. Traders watching this currency pair closely might identify RSI’s signal, then wait to see if MACD aligns—and potentially open or close a position as a result.
Exit a Position When MACD and RSI Diverge
In the same way that traders may open positions when MACD and RSI indicators confirm one another, traders may choose to close out a position when one of these indicators signals a shift in momentum.
Depending on your individual trading strategy, the rationale behind this decision can vary. Some traders will argue that the divergence of one indicator weakens the signal of the other indicator. Others may feel that one signal’s change of momentum may be a harbinger of the other signal’s change of direction and a corresponding shift in price movement.
Regardless of your evaluation, the divergence of MACD and RSI indicators is a notable development and may play a role in your decision to maintain or close out a position.
Use Stop-Losses for Risk Management
While MACD and RSI are popular indicators to pair together because of their proven value over time, it’s possible for these indicators to give false signals—even when combined with one another. As a trader, you should always embrace risk management practices that insulate you against losses resulting from these false signals.
When RSI and MACD agree, the signal they offer may be more reliable and give you more confidence. But they aren’t foolproof, and overconfidence in these indicators can lead to costly losses.
Other Indicators Used with MACD and RSI
Seasoned forex traders understand that the best trading strategies combine multiple indicators and chart patterns to validate trading opportunities. While MACD and RSI may become core indicators in your trade analysis, you may also want to incorporate additional indicators as part of your due diligence.
Common indicators used with MACD and RSI include:
- Simple moving average (SMA): SMA can offer additional insights into whether forex price movement is likely to change direction.
- Volume-weighted average price (VWAP): Based on price movement and volume, this offers another calculation to confirm the insights offered by MACD and RSI.
- Bollinger Bands: If you’re anticipating a price reversal, it’s always helpful to determine whether the price is approaching one of these bands—especially if you’re expecting traders to open or close positions based on these levels.
Final Thoughts on Using MACD and RSI Together
The more you test and refine your forex analysis strategy, the more likely it is that combining MACD and RSI will be just one component of a larger, more complex trading strategy.
That said, all traders have their favorite indicators they like to use, and amateur traders may be on the hunt for simple indicators and strategies that can help them find their footing as they gain experience in trading. MACD and RSI can be a profitable combination for both amateurs and experts.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.