Friday, April 19, 2024

Relative Strength Index (RSI)

RSI or Relative Strength Index is a technical indicator that measures the strength of a currency pair by comparing its upward movements to its downward movements over a given time period. .

It does this by tracking recent price increases and decreases and comparing them to the current price.

RSI indicator was created by J. Wells Wilder Jr.. First appeared in 1978 in his book “New Concepts in Technical Trading Systems”.

RSI is considered a Momentum Indicator, which means it is used to determine the speed and strength of price movements and whether underlying momentum is strengthening or weakening.

In addition to helping traders identify price momentum, RSI is also used to identify overbought and oversold conditions, as well as divergence and hidden divergence signals

What is the RSI indicator?

The

RSI appears as a oscillator (a line chart that oscillates between two extremes), and oscillates between 0 and 100.

RSI

Uptrend and Downtrend

  • In a uptrend or bull market, the RSI tends to remain in the 40-90 range, while the 40-50 area acts as support .
  • In a downtrend or a bear market, the RSI tends to stay in the 10-60 range, while the 50-60 area acts as resistance .

Default Settings

The default period setting for the

Relative Strength Index (RSI) is 14 periods.

Traders do use different values, usually ranging from as low as 2 periods (for weekly charts) to as high as 25 periods (for short-term time frames).

How to trade RSI

The Relative Strength Index (RSI) can work in a few different ways. Available for:

  • to confirm new trends.
  • advises when recent price movements might reach “overbought” and “oversold” levels .
  • WARNING Potential price reversal due to the difference between actual price and the RSI indicator.

Let’s review the different ways to generate trading signals using RSI.

Overbought/Oversold (trend reversal)

As price falls, the RSI will move towards 0. In the contract, as the price rises, the RSI will move towards 100. The more extreme the value, the more “overbought” or “oversold” the currency pair is.

  • is above the upper limit of 70 indicating an overbought condition.
  • Lower ranges below 30 indicate oversold conditions.

The overbought signal indicates that the recent price rally may be (temporarily) over and prices may soon fall.

Oversold signal indicates that the recent price decline may be over (temporarily) and prices may rebound soon.

Convergence/divergence (strength of trend)

  • Convergence: When RSI changes in the same direction as price, it indicates underlying trend strength and an increase in bullish momentum.
  • Divergence: When the RSI moves in the opposite direction to the price, it indicates underlying trend weakness and diminishing bullish momentum.

When the RSI reaches overbought or oversold levels, you should consider it a Warning AlertThe current trend may soon run out of steam.

Just because the RSI moves into overbought or oversold levels does not guarantee that the trend will reverse, just that there is a possibility.

Buy Signal

Oversold signal (trend reversal)

A buy signal occurs when the RSI falls to oversold levels (30 or lower) and then rises back above 30.

Uptrend Alert (Trend Confirmation)

A buy signal occurs when the RSI was previously below 50 and subsequently moves back above 50.

Bullish divergence signal (trend reversal)

A buy signal occurs when a bullish divergence forms between the price chart and the RSI indicator. Bullish divergence is when RSI forms higher lows and price forms lower lows.

Sell signal

Overbought signal (trend reversal)

A sell signal occurs when the RSI rises to overbought levels (70 or higher) and then falls back below 70.

Downtrend Alert (Trend Confirmation)

A sell signal occurs when the RSI was previously above 50 and subsequently falls back below 50.

Bearish Divergence Signal (Trend Reversal)

A sell signal occurs when a bearish divergence forms between the price chart and the RSI indicator. A bearish divergence is , where the RSI forms lower highs while price forms higher highs .

How to calculate RSI

Calculating RSI is a multi-step process that involves measuring relative strength by comparing average periodic gains and losses.

This is done by:

  • Average Return: Return is the positive change in periodic closing prices. To calculate the average gain, add all periodic gains and divide by the period itself (total gain/period).
  • Average Loss: A loss is a negative change in the periodic closing price. To calculate average losses, add up all period losses and divide by the period itself (total losses/period).
  • Relative Strength (RS): Relative strength is calculated by dividing average gains by average losses (average gains/average losses).

Let’s look at the RSI formula using the default 14 period setting:

RSI = (100 – (100 / (1 + RS)))

In the above formula, RS represents “relative strength”.

Now we need to calculate Relative Strength (RS).

RS = (14 EMA on the last 14 up bars) / (14 EMA on the last 14 down bars)

After determining the value of RS, you can apply the result to the first formula. This will give you the current RSI value.

If you want to learn more foreign exchange trading knowledge, please click: Trading Education.

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