How to Use the Relative Strength Index (RSI)

Contributor, Benzinga
April 23, 2024

If you’re looking to enhance your technical forex trading skills, then understanding the Relative Strength Index (RSI) and how to interpret it can provide a valuable addition to your trading arsenal.

In this detailed guide, Benzinga will walk you through just about everything you need to know about the RSI as a forex trader, including what it is, how to calculate it, its limitations and practical strategies for incorporating it into your trading plan.

What is the Relative Strength Index (RSI)?

The Relative Strength Index (RSI) is a momentum indicator developed by J. Welles Wilder Jr. that measures the magnitude of recent price or exchange rate changes to evaluate whether a tradeable asset is overbought or oversold.

By evaluating recent market valuation changes, the RSI offers insightful perspectives regarding prevailing market trends and sentiment. Traders using technical analysis often employ the RSI to look for overbought or oversold conditions in a market, since such situations can help them anticipate a possible trend reversal and make better trading decisions.

RSI values oscillate between 0 and 100. Readings below 30 suggest oversold conditions that may be toppish, while those exceeding 70 indicate an overbought market that could be ripe for a downside reversal. The RSI can also be used effectively along with price or exchange rate charts to detect divergences that signal potential turning points in the market.

How to Calculate RSI

Computing the RSI involves a two-part calculation process that determines average gains and losses over a specified duration of typically 14 periods. To calculate RSI levels, follow these basic steps:

• Select a steady timeframe to compute the RSI. Conventionally, a 14-day set period of time is used, although flexibility prevails contingent upon user discretion. For demonstration purposes, this article adheres to the conventional 14-day timeframe.
• Determine the positive increments (ascendant closures) and negative decreases (descendent closures) that occur during every time period. You can compute the initial net gain (NG) by taking the absolute value of the difference between the current session’s close and the preceding session's close as follows:

NG = |Current Close - Previous Close|

• Compute the total net gain (TNG) and total net loss (TNL) amassed throughout the designated time period as follows:

TNG = Net Gain_{1} + Net Gain_{2} ... + Net Gain_{n}, where n <= set period

TNL = Net Loss_{1} + Net Loss_{2} ... + Net Loss_{m}, where m <= set period

• Summarize the daily net gains and losses individually, incorporating every instance within the defined time window.
• Compute the Average Gain (AG) and Average Loss (AL) by computing the cumulative positive and negative closure variances, then dividing those by the number of time periods using the following equations:

AG = TNG / (set period / 2)

AL = TNL / (set period / 2)

Use the following special formula to compute the RSI value:

RSI = 100 — [100 / (1 + (Average Gain / Average Loss))]

• Moderate the findings by amalgamating consecutive outcomes across myriad phases to diminish instability and procure increasingly precise appraisals.
• After completing these calculation stages, the resulting RSI value can be used to illustrate the degree of recent market volatility and offer guidance concerning overbought or oversold market conditions. This computational method also permits you to tailor the set period parameter according to your strategic requirements and trading timeframe, providing extra flexibility for various technical analytical applications.

While manual calculations can provide insights into the RSI’s mechanics and what influences the indicator’s value, most modern charting platforms offer automated indicator tools you can use to simplify this task. Taking advantage of this convenience lets you focus instead on understanding how to trade using the RSI, which will be discussed in the following section.

How to Trade Using the RSI

Traders can use the RSI to identify potential trading opportunities by looking for overbought and oversold conditions, divergences and trend reversals. Here are some ways to trade using the RSI.

Oversold Conditions

Within financial markets, oversold trading conditions arise when an extended downturn drives an asset's value significantly lower than its perceived fair worth. During such phases, market participants frequently view the affected instruments as being undervalued, creating an expectation for an eventual exchange rate or price rebound. Recognizing these circumstances plays a key role in devising effective trading strategies based on the RSI, particularly when using contrarian approaches focused on exploiting temporarily overdone valuation situations.

When technical traders monitor the RSI value, observing a decline below the 30 level commonly denotes an oversold situation. Given this indication, many traders interpret this circumstance as a promising signal to buy that could present an opportunity to either square shorts or go long with the idea that the overdone declining market momentum may soon reverse, sparking a market rebound.

Using the RSI to pinpoint such undersold instances allows traders to adopt proactive measures thereby improving their ability to respond quickly to fluctuating market conditions and boost trading profits. Keep in mind, however, that not all oversold situations result in immediate rebounds, so look for additional confirming factors before entering into a long position based on an oversold RSI level.

Overbought Conditions

When the RSI rises above 70, it generally suggests that overbought conditions exist in the market. Such situations suggest that the asset has experienced significant appreciation and might soon face corrective downward pressure from profit-taking.

While trend traders may choose to exit their long positions during these times, swing traders might see it as an opportunity to short the market. Conservative traders observing an overbought RSI value will generally wait for a confirmation sign like bearish divergence to occur before acting upon the overbought signal as a signal to sell based on expectations of a market reversal to the downside.

Divergences

Traders using the RSI should pay close attention to divergences, which are situations where the RSI indicator and the underlying asset’s price or exchange rate move in opposite directions. Divergences are especially valuable to traders because they can indicate a potential market turning point.

These directional discrepancies hint towards a potential underlying shift in market sentiment and can serve as early warnings for upcoming trend reversals. Bullish divergence occurs when the exchange rate or price is making lower lows but the RSI forms higher lows, while bearish divergence happens when exchange rates reach higher highs yet the RSI records lower highs.

Bearish divergences that occur in overbought territory and bullish divergences seen in oversold territory are considered significant market reversal signals.

Consider the trading example of a trader who uses a EUR/USD daily chart with the RSI shown in the indicator box below the exchange rate chart for that currency pair to assist them in making trading decisions.

Observing this indicator along with exchange rate fluctuations can help you see how to apply the RSI in real-life trading scenarios using an analytical approach like the following:

• Identify prior market tops or bottoms by reviewing the EUR/USD chart for market reversals.
• Observe the corresponding RSI values that occurred during these critical turning points. Look for overbought or oversold levels and any divergence of the RSI relative to the EUR/USD exchange rate.
• Use the RSI indicator to validate or reject potential trade entry points and to identify potential tops and bottoms as they form.

By using the RSI indicator in your trading plan like this, you can increase confidence in your trading decision-making process and potentially generate more profitable forex trading opportunities.

Leveraging the RSI when trading forex helps foster discipline, reduce emotion-driven errors and promote consistent trading behavior in diverse market environments. This section will focus on how traders using trading strategies can include the RSI effectively to improve their overall trading results.

For successful day trading, consider setting up the RSI indicator to use shorter or lower periods of time such as 14 hours rather than 14 days. These more appropriate settings for intraday trading activities tend to allow for quicker trade signal generation. This lets speculating day traders capitalize on rapid exchange rate movements more effectively and profitably.

Day traders typically look for overbought and oversold levels on the RSI as well as divergences relative to the price or exchange rate, to operate as a signal generation technique and to forecast possible market corrections or reversals.

Traders who operate using swing trading strategies can use the RSI effectively by using it to trade trends and counter-trend pullbacks in larger market moves they identify. During uptrends, swing traders would typically buy dips by entering into long positions near local support points when the RSI reaches oversold conditions below 30 after peaking.

To trade corrections, they might sell into overbought levels when the RSI shows bearish divergence relative to the price or exchange rate. Similarly, in downtrends, swing traders might look for selling opportunities around local resistance points when the RSI becomes overbought (above 70) during a corrective rally.

They can also close out shorts and go long when the RSI demonstrates oversold levels while showing bullish divergence compared with the price or exchange rate.

In contrast to day trading, trend trading requires taking a longer-term perspective on the forex market. Trend traders can typically use the standard 14-day RSI strategy parameters and watch for an overbought condition in an uptrend to suggest profit-taking on long positions or oversold conditions in downtrends to indicate that shorts should be covered. They might buy if the RSI drops below 30 in an uptrend or sell if the RSI rises above 70 in a downtrend.

For instance, consider the situation where the RSI surpasses 70 in overbought levels during an established uptrend that a trend trader has been following with a long position.

At the same time, divergence is also showing to suggest a lack of upside momentum where the exchange rate has been making higher highs but the RSI has not. In this case, the trader could consider taking profits on that long position, at least until a stronger exchange rate or price recovery presents itself to take the market to new highs.

If they remain bullish, they could monitor the market closely to look for opportunities to buy to open another long position to profit from a subsequent market recovery in the direction of the underlying uptrend.

RSI vs. MACD

Both the RSI and the Moving Average Convergence Divergence (MACD) oscillator are widely recognized momentum indicators, but they differ substantially in terms of the calculation method used and the trading signals they provide.

While RSI lets traders focus on measuring overbought and oversold market conditions that can lead to market reversals, the MACD can help traders assess trend shifts and provide actionable trading signals.

If you intend to use both of these indicators, remain prepared to encounter occasional conflicting signals from these oscillators that each measure momentum, although in different ways. Remember to watch for divergence and use your discernment to develop an adaptable trading strategy to help you deal constructively with situations where these popular indicators give conflicting signals.

Why is the RSI Important in Forex Trading?

Using the RSI provides many advantages for forex traders, enabling them to:

• Spot overbought and oversold conditions: The RSI helps traders find situations where an instrument is either too expensive (overbought) or cheap (oversold). If the RSI goes above 70, it usually means the currency pair is overpriced and might correct itself shortly. When the RSI drops under 30, it shows the currency pair being underpriced and possibly ready to rise. Knowing these stages lets traders decide when to enter or leave trades wisely.
• Recognize divergence to signal trend reversals: The RSI can show regular and hidden divergence relative to the market, which hints about imminent market corrections and trend reversals. Spotting these subtle signals can give forex traders an edge in recognizing shifting market moods so that they can react accordingly.
• Verify breakouts: The RSI can serve as a useful trade confirmation indicator when markets break out of chart patterns or breach important support or resistance levels. Seeing movements in the RSI that are consistent with market moves can strengthen your trust in a possible trade opportunity.
• Locate probable support and resistance levels: The RSI can aid forex traders in discovering support and resistance zones, adding a helpful reference indicator to augment conventional currency pair chart studies. Significant slope shifts in the RSI line can signal changing engagement from participants, highlighting potential battleground levels between buyers and sellers.

Limitations of the RSI

Despite its considerable merits in forecasting market reversals, the RSI is not foolproof, and the indicator can present drawbacks in certain situations. These include:

• The RSI can give false signals leading to unprofitable trade entries or exits.
• The RSI lacks the ability to forecast the extent of market moves accurately.
• Optimal trading results generally require the RSI to be combined with and used alongside complementary technical indicators.

Keep these limitations firmly in mind since it remains vital to acknowledge such constraints and exercise sound judgment when interpreting RSI signals.

Continue Learning and Practicing to Master RSI Trading

This guide to the RSI has introduced you to the fundamentals of its common usage among financial markets traders. You are now empowered to use this popular indicator to recognize overbought and oversold market conditions, exploit and profit from divergences relative to the price or exchange rate of an asset and formulate lucrative forex trading strategies.

To get started using this excellent technical trading tool, make sure to familiarize yourself with the proper RSI parameters for the timeframe and market you intend to trade. You will also want to integrate proven methodologies into your strategy and remain vigilant as you start to use it to avoid pitfalls. Remember to maintain a continuous learning process to elevate your trading skillset as you progress toward mastering RSI trading.

Q

What are the best RSI settings to use?

A

The default RSI settings of 14 time periods will generally suffice for most traders, but adjustments may make sense depending on individual preferences and trader objectives. A shorter time period setting of 14 hours may make sense for scalping or other intraday trading activities, while a 14-day setting seems preferable for swing and trend traders who tend to focus on longer-term moves.

Q

Which timeframe is best for RSI?

A

Most traders use the 14-period default timeframe parameter for the RSI, although the length of the period used often varies from 1 hour to 1 day depending on the time horizon of your trading strategy. Shorter durations tend to suit day traders seeking swift responses, while more extended timeframes cater to swing and trend traders looking at longer-term market moves. You will want to select a time period length that aligns best with your strategic goals and risk tolerance.

Q

What is a good relative strength index?

A

The RSI using its default parameter of 14 time periods is widely considered one of the best technical indicators to help traders assess market momentum and forecast market reversals. The length of the time period selected by traders using the RSI tends to depend on their typical trading time horizon, with short-term traders using shorter time periods like 1 hour and longer-term traders using longer time periods like 1 day.

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