Relative Strength Index (RSI): Definition and its Uses
What is the Relative Strength Index ?
The RSI, created by J. Wilder Welles, is an oscillator that tracks the change of price and speed movements. The RSI oscillates from zero to 100. The RSI is historically rated over-bought when over 70 and over-sold if below 30. Signals can be created by looking for divergences and failure swings. General trends can also be established through RSI.
How do I Trade using RSI?
Stochastic indicators can be applied to the RSI. Depending on if the market is oversold or overbought.
Below is a four hour eur/usd table. Eur/usd had fallen the week, dropping over the span of two weeks to around 400 pips. It was still traded under the 1. 2000 handle on june 7. RSI fell below 30 however, indicating that there could be no more sellers left on the board and that the move might be over.
Price then changed and over the next few weeks went straight upward. The RSI is a secondary predictor. This implies that you use it in combination with at least one primary predictor (support and resistance, volume, trend line, price sequence). It can be done to validate what is seen on the primary predictor. Whether you use it to determine direction or as a trigger does not matter, as long as it is used alongside another indicator it is fine.
How is the RSI Calculated ?
DESCRIPTION: Relative strength is calculated using the formula
RSI = 100 – (100/1+RS)
RS (Relative Strength) =
Average of X days up closes / Average of X days down closes
Wilder used the 14-day RSI, which is still the most commonly used RSI. An analyst is, however, free to decide the number of days to compute the same.
For instance, it is presumed over a 14-day trading period that a security has produced positive returns on 9 days and negative returns on 5 days. In this case, you can calculate the RSI as follows
1. In each of the 9 days up determine the actual benefit. Add each day’s total benefit, and divide by 14. That will give the figure of the average up closes.
2. Calculate the absolute loss for every 5 days. Add each day’s absolute loss, and divide by 14. That will give the figure of the average down closes.
3. Dividing the average up closes by the average down closes gives us relative strength.
4. The figure is further standardized using the formula above to ensure it ranges from 0 to 100.
Advantages of RSI
1. Price bottoms and price tops will arise well after they have entered oversold and overbought areas. Which simply means that if you see an RSI below 30 level/over-sold region, there is no guarantee that prices will start heading up with immediate effect. Similarly, if RSI has gone past 70 level, this does not mean that price will start heading downwards.
2. RSI indicators will stay over-sold or over-bought in a highly trending market for a prolonged period of time and therefore send you multiple false buy or sell signals. The chart below illustrates the market in a clear uptrend, and how the RSI predictor behaves in such a case by sending RSI multiple false selling signals.
Disadvantages of RSI
The RSI itself performs the job it was delegated to do mathematically. Where it fails, actual market situations can not necessarily match or comply with the technical indicators, just like every other indicator.
This is perfectly normal. Markets are dynamic and are often rather irrational. Technical indicators can ‘indicate’ only they cannot predict. There’s no magic indicator that will tell when to join or leave a trade with certainty. If they were, it would be done by everybody so there would be no competitive demand because everybody would purchase, and at the same time everyone would sell.
How can a Trader Interpret the RSI?
There is another way a trader could interpret the buy and sell RSI signals. This and how to interpret divergences between RSIs.
An alternate way for the RSI to offer buy and sell signals is shown below:
A trader may buy when both the price and the RSI rise and the RSI crosses the 50 line. Similarly, when both the price and the RSI fall and the RSI cross below the 50 line, a trader might sell.
According to Wilder, divergences indicate a possible reversal stage since the directional momentum does not validate size. There is a bullish divergence where the underlying security allows a lower low and RSI creates a higher low. The lower low is not supported by RSI and this suggests a boosting momentum. Bearish divergence occurs when the security records a higher high, and RSI forms a lower high. The new high is not confirmed by RSI and that shows weakening momentum.
Is the RSI a Reliable Indicator?
The RSI is considered to be a relatively reliable indicator of shares overbought or oversold. However, many people fail to understand how the trade signals can be impacted by changing some of its parameters like its timeframe. As such, they may fail to set the right timeframe that suits their trading strategy.
Between 2 and 6 lies the best timeframe for RSI. Although for certain cases the default 14 cycles are perfect, intermediate and experienced traders can marginally decrease or raise the RSI timeline based on whether the role they join is long-term or short-term. Short-term traders should prefer shorter periods while long-term traders are expected to gravitate to longer. However, the best edges are generally found with timeframes ranging from 2 to 6.
What is RSI in Trading ?
Using RSI when trading a stock market is historically deemed overbought above the 70 mark and you should consider selling. This number is not written in stone, others suggest that 80 is a safer point in a bull market to imply an overbought condition because stocks often sell at higher valuations in bull markets.
Similarly, if the RSI reaches a price of 30 it is deemed over-sold and you should consider purchasing it again. Again in a bear market, make the adjustment to 20. The less number of days the more erratic the RSI becomes, and the more likely extremes it can reach. A longer-term RSI is more rolling, and much less fluctuating.
When it comes to the RSI, different commodities and contracts have different threshold levels. For some contracts, stocks will reach as high as 75 to 80 before slipping down and some would have a difficult time getting through 70.
A trader should warn of spikes or unexpected fluctuations while utilizing RSI in trading, because they may produce inflated RSI numbers and display a false buy or false sale. RSI can also be seen as a complement on any other measure. If combined with trendlines, the RSI may also be utilized easily, as the two also display correlating values.
Does the RSI Have Limitations ?
The RSI compares bearish and bullish price momentum and displays the results that could be placed in an oscillator under a price chart. The signs, like most technological indicators, are most accurate as they adhere to the long-term pattern.
Real signs of reversal are uncommon, and can be hard to distinguish from false alarms. For illustration, a false positive will be a bullish reversal accompanied by a rapid fall in one stock. A false negative will be a scenario when there is a bearish crossover, and the stock has unexpectedly exploded upward.
Because the indicator shows momentum, when an asset has substantial momentum in any direction, it will remain overbought or over-sold for a long time. Hence, the RSI is particularly effective in an oscillating market where the asset price alternates between bullish moves and bearish.
The RSI Could be Setup in Two Ways, How?
This measure can be set up in two ways.
The easiest way is to click the tab ‘List of Indicators’ located on the upper panel of the terminal and select ‘Oscillators’ – ‘RSI’.
Another option is to choose ‘Insert’ – ‘Indicators’ – ‘Oscillators’ – ‘RSI’.
What other Indicators Work Well with the RSI ?
The MACD and RSI can be used separately, but they can be used together to help avoid false triggers.
Moving Average Convergence Divergence
This three-step process is based on the RSI to indicate and the MACD to confirm a modification:
1. RSI warns you about an overbought or undersold price before it returns to line 30 or 70;
2. MACD provides the point of contact to join as the MACD line crosses the signal line; and
3. You will look at the exact price for your entry at this stage.
While both the RSI and the MACD are considered momentum indicators, the MACD scrutinizes the bond between EMAs, while the RSI measures changes in price as they relate to the current highs and lows of prices. Such two indicators are sometimes used in tandem to provide investors with a more full quantitative view of the market.
If you’re accustomed to reading the MACD and RSI indicators, stops and profit goals such as trailing stops and defined sums may be set to mitigate the risk.
Finally, note that indicators are just indicators. Although they can’t predict any single result, they are extremely helpful to indicate what is expected to happen.
Moving Average Crossover (MAC)
Moving average crossovers can also be used to provide verification of RSI indications of over-bought or over-sold market conditions. Since the RSI is also used to obtain an early indicator of potential trend shifts, it is better suited to complement the usage of the RSI by using exponential moving averages (EMAs) which react faster to recent price changes, and fairly short-term MAC such as the 5 EMA crossing over the 10 EMA.
The 5 EMA crossing from above to below the 10 EMA is a confirmatory indication of the possible trend reversal and overbought conditions.
Conclusion: RSI Forex Trading
Lots of people dive into trading using the forex RSI indicator, that new traders often begin to trade without testing different parameters, or giving themselves proper education on an indicator’s proper interpretation so as to make fast money.
Because of this, the most generally tainted MT4 indicator has become the RSI. Once properly understood and applied, it has the capability to indicate if prices are trending, if a market is over-sold or overbought, and the best time to enter or exit a trade. It can also point out time-frame that are most effective for trading, and provides information to determine key support and resistance in price levels.
You can get technical info from the RSI, as well as buy and sell signals. It is vital that you first practice on a demo account first and then apply them to a live account.
Furthermore, the RSI strategies can match any forex trading strategy you may already have used.
The use of divergences amid the prices on the chart and RSI is considered to be an aggressive use of RSI, but it also allows early discovery of trends, leading to increased profits. For example, we may see lower bottoms for prices in a downtrend but higher bottoms on the RSI.
This indicates the downtrend’s strength and momentum is decreasing, making a price rise more likely. In an uptrend the same is valid, but we can see lower lows in the rsi, although higher peaks are already being achieved on the market map.
The RSI is used to find situations in capital markets which are overbought and oversold. This is done by moving up and down within a range of 0 to 100 as an oscillator type indicator, with 0 representing the most over-sold conditions, and 100 representing the most over-bought conditions.
Typically any reading above 70 is considered over-bought and ripe for reversal, whereas less than 30 readings are considered over-sold and also ripe for reversal. Some traders use the levels 80 and 20 as their points of signal.
While they are both considered indicators of momentum, the moving average convergence divergence measures the bond between EMAs while the RSI measures changes in price which relates to the current highs and lows of prices. These two metrics are sometimes used in tandem to provide investors with a more full quantitative view of a sector.
The default 14-period rsi setting works perfect for swing traders. But other intraday traders consider it lacking, because it creates unusual trading signals. Any traders counter this question by reducing their timeline. Others lower setting the RSI period to get a more sensitive oscillator.
Some traders use the default value for the RSI as 14. That means the indicator will go back 14 periods or time frames based on the chart being used (14 days on a daily chart, 14 hours on an hourly chart, etc. ) and calculate on that basis.
RSI’s best trend settings are 14-period RSI with overbought as 60 and overbought as 40. You can see below video for user interpretation, the best environment for reversal detection is rsi 14 with overbought as 70 and overbought as 30.
RSI is listed among the most common indexes for trading. It is with good purpose, since as a part of the family of oscillators, RSI will allow one to evaluate pattern, time entries and more. RSI oscillates and is restricted from zero to 100.
The RSI is a statistical metric used in stock market research. The RSI is most commonly used on a 14-day timeframe, measured on a scale from 0 to 100, with high and low levels marked respectively at 70 and 30.