Relative Strength Index what is it? In this post you will learn a lot about this popular forex indicator including:
- 3 main way to trade the RSI indicator
- 5 things you need to know about the RSI indicator
- who is the genius that developed the Relative Strength index indicator?
- definition of relative strength index
- what is the formula to calculate the relative strength index?
- what a relative index chart looks like on mt4 trading platform
- disadvantages of the RSI indicator
and lots more so to find out, keep reading…
WHAT IS THE RELATIVE STRENGTH INDEX-RSI?
This is the definition of the Relative Strength Index indicator: The RSI (Relative Strength Index) is a technical indicator that measures the momentum of recent gains and losses based on closing prices of candlesticks over an “x” number of periods in order to determine what is called an overbought or oversold conditions of the market.
WHO DEVELOPED THE RSI INDICATOR?
The Person that developed the RSI Indicator was an American, J.Welles Wilder, Jr .
He also developed other popular forex indicators like Average Directional Index, Average True Range and Parabolic SAR.
Here was a mechanical engineer, later turned real estate developer who later became a technical analyst.
RELATIVE STRENGTH INDEX FORMULA
This is the formula for Relative Strength Index:
100 RSI = 100 - -------- 1 + RS RS = Average Gain / Average Loss
In order to calculate the relative strength index, you first need to calculate the RS, which is the Relative Strength.
But then, to calculate Relative Strength:
- you need to know how to calculate the Average Gain
- and also calculate the Average Loss.
This RSI calculation is based on 14 periods, which is the default setting that is set in the MT4 trading platform.
Note also here that the Losses are expressed as positive values, not negative values.
The very first calculations for average gain and average loss are simple 14 period averages.
First Average Gain = Sum of Gains over the past 14 periods / 14.
First Average Loss = Sum of Losses over the past 14 periods / 14
The second, and subsequent, calculations are based on the prior averages and the current gain loss:
Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.
Note here that taking the when you take the previous average gain (or previous average loss) plus the current value of gain (or loss) what you are doing is applying a smoothing technique which is very similar to the the smoothing technique that is used in the calculation of exponential moving average.
So what does smoothing effect have on the Relative Strength Index? Well it means, the RSI value becomes more accurate as the calculation period extends.
RELATIVE STRENGTH INDEX CHART
So when you use the relative index formula to calculate all the RSI values and plot them on a chart, this is what you get: a relative strength index chart like below. This is based on the MT4 Trading Platform:
5 THINGS YOU NEED TO KNOW ABOUT THE RELATIVE STRENGTH INDEX
Here are 5 things you need to know about the RSI Indicator:
- The relative strength index is very popular forex indicator that is used by many traders to analyse the forex market (or can be others like shares or commodities).
- The RSI is momentum oscillator and what it does it that it measures the magnitude and velocity of directional price movements.
- The RSI calculates momentum as the ratio of higher closes to lower closes….in simple terms this means if there are more candlesticks that have closes that are higher(gains), the RSI increases in value and if there are more candlestick with lower closes(losses),the RSI value decreases.
- the Relative Strength Index in the MT4 trading platform has a default value of 14 period which means that it measure the price momentum over the last 14 periods and these periods can be days, hours or minutes or whatever timeframe you use on your trading chart.
- the RSI has a scale from 1-100 and many traders like to use these two levels, the 30 and the 70.
WHAT DOES THE RSI TELL YOU ABOUT THE MARKET? 4 THINGS
Remember, the Relative Strength Index Indicator Is a oscillator so it fluctuates between one 0-100 level so what does this actually tell you?
Well, it tells you this:
- if you see the RSI below the 30 level, it tells you that price has been weak (falling).
- this RSI value below 30 level also is in a region known as the oversold region and therefore the price may be due for a reversal.
- if you see the RSI level above 70, it tells you that the price has been strong (rising).
- however, in this RSI 70 level, the price is in a region called as the overbought region therefore may be due for a reversal.
As you can see, the RSI indicator can potentially show you the oversold and overbought conditions in the forex market.
3 SIMPLE WAYS ON HOW TO TRADE THE RSI INDICATOR
The are 3 main ways I know off that you can use to trade with the Relative Strength Indicator and they are:
- trade when the RSI is in the oversold regions, which means you buy.
- trade when the RSI in the overbought region, which means you look to sell.
- trade when you see RSI divergence, this simply means that price and RSI are going in completely different directions, for example, you will see price making a higher high but then on the corresponding time on the RSI indicator window, you will see the RSI indicator making a lower high. This behaviour is called divergence.
Ok, let’s go through each of these 3 ways of trading the RSI indicator…
#1: How To Trade RSI when its in the oversold region
This is fairly straight forward:
- market must be in a downtrend
- you see the RSI has crossed below the 30 level and that indicates that its is not in an oversold region and there’s potential that price can start to head back up.
- so what you do is wait for the RSI line to start turning back up to the 30 level line and crossing it.
- when it crosses the 30 line, that is your signal to buy.
#2: How To Trade RSI when its in the overbought region
This is the exact opposite of the above:
- market must be in an uptrend.
- you see the RSI has crossed above the RSI 70 level and that indicates that its is now in an overbought region and there’s potential that price can start to turn around and fall back down.
- so what you do is wait for the RSI line to start turning back down to the 70 level line and crossing it.
- when it crosses the 70 level line, that is your signal to sell signal.
#3: How To Trade RSI Divergence
In order to trade RSI divergence, you must be able to spot the sell trading setup and buy trading setup when it is forming.
Let me give you an example of a sell setup…for a sell setup, remember, the market must be in an uptrend first:
- make sure that the RSI oscillator line is above 70 when you want to trade RSI divergence.
- in an uptrend, price will make a high which will correspond to the high of the RSI indicator
- but then on the next higher high the price makes, you will see that RSI makes a lower high.
- this tells you there’s a RSI divergence happening and there’s potential for price to start moving back down and then you should start looking to sell.
Here’s an example of RSI divergence forming in an uptrend and the sell setup:
For a buy trading setup, you do the exact opposite of the above:
- make sure that the RSI oscillator line is below 30 when you want to trade RSI divergence.
- in a downtrend, price will make a low which will correspond to the low of the RSI indicator
- but then on the next lower low that price makes, you will see that RSI makes a higher low.
- this tells you there’s a RSI divergence happening and there’s potential for price to start moving back up so now you should look to buy.
2 DISADVANTAGES OF THE RELATIVE STRENGTH INDEX INDICATOR
in forex trading Here are the disadvantages of the Relative Strength Index Indicator:
#1: Price bottoms and price tops can happen long after oversold and overbought zones reached. Which simply means that that if you see an RSI below 30 level /oversold region is not a guarantee that as soon as the that happens, price will immediately start heading up. Similarly if RSI has gone past 70 level does not mean that price is going to start heading down.
#2: RSI indicator can remain oversold or overbought for an extended period of time in strong trending market and therefore giving you many false buy or sell signals. The chart below shows the market in a strong uptrend and how the RSI indicator behaves in such a situation by giving many false sell signals:
RSI INDICATOR FOREX TRADING STRATEGIES
If you are interested about RSI based forex trading strategies or forex trading strategies that use relative strength index indicator as part of their trading rules, then here’s a list of these forex trading strategies forextradingstrategies4u:
- Simple RSI Forex Trading Strategy
- 21 RSI With 5EMA And 12 EMA Forex Trading Strategy
- Simple Moving Average Forex Trading Strategy With 5SMA, 10 SMA, Stochastic & RSI indicators
- 5 SMA With 5 RSI Forex Trading Strategy
- 20 SMA With RSI Forex Trading Strategy
- Cowabunga Forex Trading System
- 10 pips a day forex trading strategy
- simple forex scalping strategy for GBPUSD and EURUSD
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