How to Trade Using the Relative Strength Index (RSI)

What is RSI?

The Relative Strength Index (RSI) is a momentum oscillator, created in 1978 by J. Welles Wilder, that has since been refined by others including Andrew Cardwell. The RSI indicator is used in technical analysis by investors to determine whether a market is overbought or oversold. When an asset is overbought, it is considered overvalued and a pullback in price can be expected. Conversely, an oversold asset is likely being undervalued and an upwards trend reversal can be anticipated. By using the RSI indicator, a trader can identify the appropriate time for market entry, and predict potential market trends.

The Relative Strength Index Explained

As an oscillator, the RSI indicator ranges in value between 0 and 100. When the Relative Strength Index is above 70, this traditionally means that an asset is overbought, signalling that investors should take a bearish stance as the price is expected to fall. Conversely, when the RSI is below 30, this usually means that an asset is oversold, pointing to an impending uptrend, and signalling to traders to take a bullish stance.

Relative Strength Index

As previously mentioned, an RSI chart can also be used to identify possible market trends. When the RSI indicator registers a value above 50, this usually signals that traders are observing a possible uptrend. Comparatively, if the RSI is below 50, a downtrend is often seen.

Relative Strength Index

Another way that investors can draw signals from an RSI chart is by watching for divergence between the patterns formed by the asset price and the indicator. Divergence occurs when the asset price records new highs or lows in price, but the RSI indicator does not correspond to these movements. According to J. Welles Wider, divergences in these patterns indicate potential reversals in market trend because directional momentum doesn’t confirm asset price. When the asset price reaches a new high, but the RSI doesn’t, this indicates a weakening of trend momentum and bearish divergence is said to occur, signalling to investors to place a sell order. Conversely, bullish divergence occurs when the asset price hits a new low that is not mirrored by the RSI, indicating strengthening momentum and signalling that a buy order should be placed.

How to Calculate RSI

The Relative Strength Index is calculated by using the following formula:

RSI = 100 - 100 / (1 + RS)

Where RS stands for the average gain of up movements divided by the average loss of down movements, during a specified time period.

RSI Indicator Settings

In regards to what settings to use for the RSI indicator, the default time period for comparing an asset’s movements in price is usually 14. This number refers to 14 periods of the timeframe being used to chart an asset. As an example, on a daily chart, the number would refer to 14 days. By setting this time period for the indicator, investors are choosing how the RSI calculation will be conducted.

Although the default time period of 14 is recommended, investors interested in long-term trading may want to increase the number, leading to fewer, but more accurate trading signals. Conversely, for short-term trading, the number can be reduced, which can lead to more frequent signals that may, however, turn out to be less reliable.

As with most technical analysis indicators, traders can also select which chart price is used in the RSI calculation. The default is usually close price, although other options including open, high and low price are also available. Which parameter to use will depend on the time-frame being charted and the instrument being traded. For example, the best setting for day trading will be different to the best one for hourly trading.

The Relative Strength Index in Real Trading Conditions

Having covered the basics about the Relative Strength Index, let’s now take a look at how this indicator works in real trading conditions. Using the RSI indicator in forex trading is fairly simple. Below is a chart of the EUR/USD currency pair between March and November 2016.

Relative Strength Index

The pair has been charted at a daily timeframe, and the Relative Strength Indicator has been calculated with default parameters (14, close price). As can be seen in the highlighted area, the RSI indicator crosses above 70, indicating the currency pair is overbought, and hinting at an impending downtrend. The asset price confirms this, as it experiences a fairly significant decline from this point. Investors that had taken a bearish stance due to the data provided by the RSI indicator would have earned a significant number of pips.

Relative Strength Index

Returning to the same chart, but focusing on a different time period, we can observe the RSI indicator crossing below 30, indicating the pair is oversold, and foreshadowing a potential uptrend. The data provided by the Relative Strength Indicator is again confirmed by the asset price, which gains upward momentum from this point. Traders that took a bullish stance based on this data would also have earned a decent amount of pips from this movement.

Relative Strength Index

Relative Strength Index

Once again looking at the same chart, but this time across two different periods, we can see multiple points at which the RSI indicator reaches 50. As is visible in the 4 highlighted sections, there were multiple instances where the indicator moved significantly above or below the 50 point, hinting at the emergence of market trends. In the instances where the Relative Strength Index crossed above 50, the asset confirmed the uptrend, experiencing steady increases in price. Similarly, when the RSI indicator crossed below 50, the asset price experienced downward movements. Traders conducting sound analysis of the EUR/USD pair during this timeframe would have been presented with multiple opportunities to profit from new market trends.

Conclusion

As we have explained, using the RSI indicator in forex trading can be a very effective way for investors to identify overbought and oversold market conditions, and predict potential trends. However, and as is the case with most indicators, the RSI should not be used as a standalone chart analysis tool. Unexpectedly large movements in an asset’s price can cause the RSI indicator to report false data. As such, it would be better to supplement its use with other indicators that provide more direct signals.

Did you know?

In terms of trading volume, the FX market is by far the largest market in the world.

Word of the day
"Fighting the Trend" - Describes a trader that places trades against the prevailing trend.
Pro Tip

It’s usually better to avoid trading when market activity is low.

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