The RSI, or Relative Strength Index, is a momentum oscillator developed by J. Welles Wilder, it measures the speed and change of price movements. The Relative Strength Index oscillates between zero and 100.
The Relative Strength Index is often considered overbought when it’s above 70, while they see it as oversold when below 30. These signals can be generated by taking a look for divergences and failure swings.
RSI can also be used to identify the general trend, by using it, you will have a relative evaluation of the strength of a security’s recent price performance and make it a momentum indicator.
Calculating the Relative Strength Indicator
The Relative Strength Indicator possess a fairly simple formula, which is:
RSI = 100 – 100 / (1 + RS)
In which RS means the average gain of up periods during the specified time frame or the average loss of down periods during the specified time frame.
This formula provides not only a momentum Indicator, but a relative evaluation of the strength of a security’s recent price performance as well. The RSI values may vary from a 0 to 100 range. It has a default time frame for comparing up periods set up to 14, as in 14 trading days.
What does Overbought and Oversold means?
These two terms describe themselves pretty quickly. When we are talk about overbought, it is defined as a period where has been a significant and consistent upward move in price over a period of time without much pullback. It is often shown as the “lower-left to upper-right” movement in charts.
In the other hand, oversold describes a period that has stayed significant and consistent downward move in price over a period, without causing much pullback. These are basically moves from the “upper-left to the lower right.”
Eventually, the price will turn around at some point since it cannot move in one direction forever. Currency pairs that are overbought or oversold sometimes tend to have higher chances of reversing course, but its time remaining overbought or oversold might stay for an extended period.
How to trade using RSI
Depending on whether the market is overbought or oversold, you can quickly pick potential tops and bottoms with RSI.
For instance, if we have a 4-hour chart of EUR/USD, which had been dropping the week and falling about 400 pips over the course of two weeks. As the time passed, it went already to be traded below the 1.2000 handle.
However, since RSI dropped below 30, it would signal that there might be no more sellers left in the market, meaning that the move could be over already. His would reverse the price and head it back up over the next couple of weeks.
How does the Relative Strength Indicator work?
There are quite a few notes you could take that will help you understand the Relative Strength Index and how to use it:
- Users consider RSI to be overbought when above 70 and oversold when below 30. Users can adjust these levels if necessary, in order to fit their security conditions.
This way, if your security is continuously reaching the overbought level of 70, you might find useful to adjust the level to 80 or so.
Do not fear if the RSI remains in overbought during strong trends, during this period it is normal to stay oversold for extended periods.
- The Relative Strength Index often forms chart patterns like double tops and bottoms, which may not show on the underlying price chart. It is recommended to keep track of this and for support or resistance on the RSI as well.
- During uptrend or bull markets, the Relative Strength Indicator will typically remain between the 40 to 90 ranges, having the 40-50 zones acting as a support.
While in downtrend or bear market, the RSI would tend to stay all the opposite, between 10 to 60 ranges with the 50-60 zones acting as resistance.
Depending on the RSI settings and the strength of the security’s or market’s underlying trend, these ranges will vary in a couple of different ways.
- When underlying prices make a new high or low, which isn’t yet confirmed by the RSI, it can signal a price reversal. If the Relative Strength Index makes a lower high and then follows with downside move below a previous low, it means that a Top Swing Failure has occurred.
On the other hand, if the RSI makes a higher low and then follows with an upside move above a previous high, it means that a Bottom Swing Failure has occurred.