Have you ever wondered how you can measure the weakness or strength of a Forex pair? Well, let me introduce you to the RSI study. The Relative Strength Index is another popular technical indicator in the Forex industry which is well followed for both, long and short term investors.
Knowing the strength or the weakness of a Forex pair could be the difference between starting a position with a plus-one pip or a minus-10 pips count due to poor opening timing. So, RSI is vital in Forex.
Let’s talk about the Relative Strength Index and how it could help you to understand market situations, divergences, extreme conditions, and reversal. Know how to use RSI; but first, the foundations.
What is the Relative Strength Index
The Relative Strength Index is a technical indicator that works as a momentum oscillator index. J. Welles Wilder developed it and published in 1978 in the book: “New Concepts in Technical Trading Systems”
The RSI provides signals about when a currency, or a pair, is oversold or overbought. It works better in short and middle term trades.
In 2017, Patrice Marek and Blanka Sediva published a paper called “Optimization and Testing of RSI”, answering the question “whether-almost 40 years after its publication-the RSI can be still useful in trading.”
The paper showed that RSI is still valid as a momentum oscillator indicator.
The Relative Strength Index compares bullish and bearish price momentum in the price of a pair or a currency. RSI oscillates between zero and 100 lines. Usually, the indicator shows overbought conditions above 70, while oversold is when it is below 30.
Traders watch RSI in Forex for divergences, trend strength, and unsuccessful swings.
RSI Formula and Calculation
The RSI formula is pretty simple and easy to find. However, it requires two steps to be calculated.
The first step in the Relative Strength Index is:
RSI = 100 – [100 / ( 1 + (Average of Upward Price Change / Average of Downward Price Change ))]
The average upward or downward is the average percentage of gains or losses in the given period. Note that the formula uses positive values for average losses, and no changes between consecutive periods are zero.
The RSI standard uses 14 periods to calculate RSI initial value. So, in the case a pair closed higher seven of the past 14 hours with an average of 1% gain. The other seven hours all finished down with an average loss of -0.8%.
The calculation for the first step of the RSI would be:
55.55 = 100 – [100 / ( 1 + (1%/14) / (0.8%/14))]
Once you have the 14 periods of data, the second step of the RSI formula can be calculated.
RSI step two = 100 – [100 / ( 1 + (Previous average gain ∗ 13 + Current gain / Previous average gain ∗ 13 + Current loss ))]
How RSI works
The RSI is plotted in a graph usually below the price chart. The indicator has two lines, the 70 and 30 levels, and a dashed line at the 50 value. Wilder recommended a smoothed moving average period of 14.
The indicator is considered overbought when above 70 and oversold when it falls below the 30 line. It can be adapted to a better fit depending on the pair. For example, if a cross reaches above the 70 level often, you can change the overbought level to 80, to have a more precise signal.
Although it is not a real representation of the price action, RSI also performs chart patterns and can show information that is not shown in the price chart.
In uptrend or bull markets, RSI usually remains in the 40 to 90 range with the 40-50 area as a support zone. On the other side, in a downtrend, RSI tends to be between 10 and 60 lines with 50-60 zone acting as resistance.
The RSI can also show divergences as when new highs or lows in a pair that is not confirmed by the indicator, it could be a reversal signal.
Furthermore, an RSI making a lower high and then a downside move below a previous low could be a top swing failure. Also, if RSI performs a higher low and then continues with an upside movement above a previous high, a bottom swing failure has occurred.
Traders well follow divergences in the Relative Strength Index. RSI’s author Wilder believes that discrepancies between RSI and price action show critical indications that turning points are imminent in the given asset.
RSI and Bullish divergence
The textbook says that a bullish divergence is when the RSI is in oversold conditions, and it is followed by a higher low that is corresponded by a lower low in the price chart. It suggests that a rising bullish momentum is on the making. With a break above oversold territory is identified as a bullish signal for a long position.
RSI and bearish divergence
On the other hand, a bearish divergence happens when the Relative Strength Index is performing in overbought conditions, and then it does a lower high that is corresponded by higher highs on the price action.
With a break below the overbought territory is considered as a bearish signal for a short position.
Problems for the RSI indicator
Like any other good indicator, the Relative Strength Index also has its ups and downs. The positive topics are well explained above, but the downsides are exposed next.
Here in Forex Traders Guide, we think that It would be better if forex traders combine the RSI with another indicator for confirmation. Also, keep in mind the following:
- RSI signals are more accurate when developed in long term trends.
- True reversal signals are difficult to separate from false alarms.
- Overbought and oversold conditions can be performed for long periods of time, so it would be better to use it in swing markets.