Relative Strength Index (RSI) Explained

Definition of the Relative Strength Index (RSI)

The RSI was created by J. Welles Wilder. The Relative Strength Index is a momentum indicator which is used for a variety of functions in forex. It is a momentum indicator which is capable of detecting overbought and oversold market conditions. The Relative Strength Index (RSI) can measure the speed and rate of change of price movements.

RSI1

The RSI is calibrated between 0 and 100. Just like other indicators which measure oversold/overbought conditions, the RSI is overbought when the value is >70 and oversold when <30. RSI can also be used to identify the general trend.

Components of the RSI Indicator

The Relative Strength Index is made up of a single line, but actually has different components such as the RS line, the average gain and average loss of a period.  The single line can be used to generate divergence trade signals, as well as crossover trades of the centre line.

The calculation of the RSI is:

RSI = 100 – (100 / (1 + RS))

The RSI is expressed as a percentage value. The higher the average gain relative to the average loss, the higher the RSI. The lower the average gain relative to the average loss, the lower the RSI value. The outcomes of the RSI calculation can be plotted on a graph, which is what is shown as the RSI-line.

Indicator Settings

The indicator is listed on the MT4 under the Oscillator category of indicators. To attach it to the MT4 chart, click on Insert -> Indicators -> Oscillators -> Relative Strength Index.

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In terms of appearance, some modifications to the look of the indicator can be made. These modifications can be either to change the colours as well as the line thickness of the indicator’s RS line.

Usage of the RSI in Forex Trading

The RSI indicator can be used in two ways as far as forex trading is concerned.

  1. As a standalone indicator

It must be pointed out however, that the RSI is not very reliable as an overbought/oversold indicator when used alone. It is however better used in divergence trades if it is to be used alone. The divergence in this case would be to look to see if the peaks and troughs of price action follow the peaks and troughs of the RSI. Trend lines are used to connect the peaks and troughs of both price action and the RSI. Whenever a divergence is detected, it represents a trading opportunity as price action will try to correct the divergence. The divergence situation is seen when the trend lines of price and the RSI are facing different directions.

RSI_diverg

However, extreme caution must be exercised in divergence trading with the RSI, as it usually fails if the trend is very strong or is being pushed by a fundamental influence. In any case, any divergence trade must only be taken when there is a candlestick or chart pattern to support its movement.

The RSI can also be used in trend trading. Here, the 50 mark is taken as the benchmark, with 40 as the lower border and 60 as the upper border of price range. RSI may bobble between 40 and 60 for a long time. A break of 40 or 60 will lead price to push to new lows or new highs respectively, before overbought/oversold regions are attained.

  1. In combination with other indicators

The primary way is to trade the RSI as an indicator which gives signals when the market is either overbought or oversold. When the RSI is 70 or >70, the market is overbought and this is a bearish signal. When the RSI is 30 or <30, this is an oversold signal and the trader would be looking to short the currency pair.

Another way traders like to use the RSI is to look at the direction of the RS line. If the RSI line is moving upwards, this means that the currency pair is in an upward trend. When the RSI is heading downwards, then the currency pair is in a downward trend. Here, the benchmark level is 50. Above 50 is a buy signal, while below 50 is a sell signal. This trade can be taken until when the RSI heads into overbought or oversold territory. This is when the trader should exercise caution and watch for a possible trend reversal.

Short Trade Entry

The short trade entry shown here is an example of how to trade a swing breakout using the RSI as a standalone indicator.

RSI

On this chart, the RSI has been edited using the Ctrl + I function. The overbought/oversold levels have been removed, and we have fitted a tight band of 45 to the downside and 55 to the upside, to hug the 50 midpoint mark.

What we see is that as price is range-bound, the RSI is also bound tightly within the 45-55 range. But the moment the RSI starts to break to the downside, the price action also breaks out of its range to the downside. This trade is not as easy as depicted; there are other factors that are considered before the trade is made. This is just for illustrative purposes.

Make sure you practice how to trade each setup on a demo account before using the indicator to trade real money. Also pay attention to risk management.

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