Welcome to today’s article on the RSI indicator. We hope that you had a great week in your trading. If not then you might want to consider looking at one of Winners Edge Trading services, click here for more information on that.
The RSI indicator is an abbreviation of the Relative Strength Index (RSI. The index was developed by J. Welles Wilder and published in 1978 in his book, New Concepts in Technical Trading Systems.
It is an indicator used in the field of technical analysis for measuring the strength or weakness of the price movements in the Forex currency or commodity. It has become one of the most popular oscillator indicators ever.
Wilder invented the indicator so as to develop a measurement for predicting turning points. When prices move substantially, at some point it is considered overbought or oversold. Wilder anticipated a a reaction or reversal and created the RSI to measure the recent trading strength/weakness.
The indicator has many benefits:
A) As a momentum oscillator it measures the velocity of price movements;
B) A trader is able to determine overbought and oversold conditions;
C) By comparing the movements on RSI of recent moves up and down, the trader can judge whether the price movement is weakening or strengthening.
The RSI in some ways is quite similar to the ADX methodology. For more information on that, read this article “the adx methodology”.
Before we analyze the advantages for your Forex trading, let us first examine how the indicator is calculated.
It is calculated using the following formula:
RSI = 100 – 100 / (1 + RS)
RS is average of x days’ up closes / average of x days’ down closes.
Basically, the measurement of momentum is the rate of the rise or fall in price. The RSI calculates momentum as the ratio of higher closes to lower closes.
–> a Forex pair with more or stronger positive changes has a higher RSI than a currency pair which has more or stronger negative changes.
The values on the RSI indicator have a minimum and maximum and vary from 0 to 100. The standard period or smoothing used for the RSI is 14. A Forex currency pair is considered to have:
a) an overbought value once the RSI approaches the 70 level or is above the 70 level. This could indicate that the currency is overvalued and the chances of a pullback increase;
b) an oversold value once the RSI approaches 30 or is below the 30 level. This could indicate that the currency is undervalued and the chances of a pullback increase;
c) reached extremes when either hitting the 80 and 90 levels at the high side or when at 10-20 mark on the low side;
d) the most neutral point at the midpoint at the level of 50.
There are many great benefits of this Forex trading tool. Currency trading becomes a lot easier and more scientific when using this tool for your FX analysis.
For example, the RSI can be great Forex asset for analyzing break outs. Please read more about break outs in this article “trading breakouts real or false.”
But the indicator always has advantages of its own. Here is the list.
1) As a momentum oscillator it measures the velocity of price movements:
The slope of the RSI is an indication of the power in the trend.
– a higher slope indicates a trend which is strong and powerful;
– a slope which is less slanted indicates a weaker trend, or even the lack of a trend.
As you can see in the example, the RSI line has an angle when in a trending mode. The RSI has no slope at all when price was in a ranging environment.
2) A trader is able to determine overbought and oversold conditions:
Not only does the RSI indicate whether the currency is in a trending mode or not, but by using the RSI values the trader can get an indication when a trend has extended to such a degree that it might be considered overextended.
If we look at the chart example then we can see that the 30 and 70 values were great indications of pending retracements or reversals. The effect this value causes depends whether or not the currency is in a trending mode or ranging mode.
When the currency is in a trending mode, the fact that the currency reaches an oversold or overbought value will have the following affects:
– It will most likely cause a pause or (relatively small) retracement and the trend most likely will continue;
– At some point of course, reaching the extreme will cause a reversal. But a trader should be careful with assuming a trend reversal which is only based on the RSI value because the currency could pause a bit, just to resume the trending mode it was already in.
When the currency is in a ranging mode, the fact that the currency reaches an oversold or overbought value will give a higher likelihood of the currency making a reversal.
The chart example shows the currency in a trending mode and in aranging mode.
On the left of the chart the EURUSD was in a strong up trend. We can see that the currency paused for significant lengths of time when the RSI approached or hit the value of 70. This is a week chart so all candles represent 1 week of trading. In this example the currency paused or retraced for 1-3 months.
However the currency did eventually continue with the uptrend after the RSI retraced to lower levels. The fact that the currency reached the oversold status only caused a pause, but not a reversal. The exception, of course, is the end of the trend when the currency then makes its drop for a reversal.
On the right of the chart the EURUSD was in a ranging mode. In this area we can see that when the currency reaches a oversold or overbought value, the effects are strong and a reversal is likely. The indicator gives a heads-up of imminent reversal coming soon and the currency changes gears for thousands of pips into the other direction.
3) By comparing the movements on RSI of recent moves up and down, the trader can judge whether the price movement is weakening or strengthening:
The RSI also has another great value and benefit. It can indicate whether price movement is sustainable or not. How?
The RSI can judge and indicate whether price is making a sustainable move by comparing price and RSI extremes with each other.
When price is making a new extreme (new high or low), the RSI should be making a new extreme as well. The reasoning is that price should be supported by power and momentum when it is making a new extreme. So a new price extreme should be accompanied by a new oscillator extreme.
- If the new price extreme is supported by a new oscillator extreme as well, then the currency is behaving in a sustainable fashion and the price movement is well balanced. This means there is less danger of trend reversal and more likelihood of trend continuation;
- If the new price extreme is NOT supported by a new oscillator extreme, then price is showing signs of weakness and the price movement is off balance. This means there is more danger of either a retracement or trend reversal and less likelihood of an immediate trend continuation (trend could continue after retracement).
You can read more about divergences in this great Forex article: “How To Predict The Future: The Power Of Divergence.”
A word of caution: please practice with the RSI tool before actually using it for live Forex decisions. This is a tool that requires sufficient Forex training and FX learning before one can use it proficiently.
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