The Relative Strength Index or RSI was developed by J. Welles Wilder and published in his book New Concepts in Technical Trading Systems, in 1978. It is one of the most well known and widely used indicators. It is included in almost every charting software on the market today.
But you may not know exactly how this indicator works or how it can be used. This post will get into how it is calculated and a few different ways that it can be utilized to execute trades.
The Calculation
RSI is a momentum oscillator, meaning that it measures directional price momentum and moves between a minimum of 0 and a maximum of 100.
It is calculated as follows:
RSI = 100/ 100-(1+RS)
Where RS = average gain / average loss
The recommended setting for this indicator is 14. So all of our examples will be shown over 14 periods.
RS is a little confusing, so let's clarify it. The most recent period is calculated in the following way.
The most recent average gain is calculated like this:
Average Gain = Sum of Gains over the past 14 periods / 14
A gain is defined as a period where the close is higher than the open.
The most recent average loss is calculated like this:
Average Loss = Sum of Losses over the past 14 periods / 14
A loss is defined as a period where the close is lower than the open.
After the most recent calculation, the following 13 periods are calculated like this:
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Average Gain = [(previous Average Gain) x 13 + current Gain] / 14
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Average Loss = [(previous Average Loss) x 13 + current Loss] / 14
So the most recent price action carries more weight in the calculation. This is similar to how an exponential moving average is calculated.
But that is only the RS calculation. The rest of the equation normalizes the indicator so that it oscillates between 0 and 100. When the indicator is 100, all 14 periods were gainers and when the indicator is 0, all periods were losers.
How to Use the RSI Indicator in Forex
The purpose of the indicator is to alert traders to possible overbought or oversold conditions on the chart. This potentially signals turning points in the market.
The default overbought setting is 70 and the default oversold setting is 30. Whenever the RSI hits 30, it represents a possible buying opportunity and when it hits 70, it is a possible sell opportunity.
Just like with any other indicator, it will not be 100% accurate. It only represents an opportunity. You will have to use your judgement as to when to take a trade.
When It Doesn't Work
In strongly trending markets, RSI can stay overbought and oversold for extended periods of time. If you were to take every single signal in these conditions, it would lead to huge losses.
For example, take this EURCAD chart. If you too every single overbought signal, it would have resulted in at least six losses and probably more.
Therefore, if you are using the RSI for Forex trading, your risk management plan must include a contingency for limiting losses in a strongly trending market. Limiting the number of consecutive losses or a maximum percentage loss are two ways to do it.
You can also use concepts such as divergence and support/resistance to try to find the very best signals. Let's take a look at how this works.
Divergence Between RSI and Price
The first way that you can potentially filter out lower quality signals is by combining the concept of divergence with overbought and oversold conditions. This may filter out false signals, but may also cause you to miss out on opportunities. Thus is the nature of trading, there are no free lunches.
In the chart above, price continues to move higher while RSI makes lower highs. This ultimately signals a drop in price. Again, this will not happen all the time, but it can give you a clue as to what is about to happen.
Support And Resistance
Finally, support and resistance within the RSI itself can be used to signal the end of a trend. Let's look at the strongly trending chart that we saw before, but from a support and resistance point of view.
While price is in a trend, you will notice that RSI continually runs into resistance until breaks out and resistance becomes support. This signals a turn in price and an end of the trend.
You will also notice that there was a false breakout, but the RSI did not stay above the resistance line. Even if you took a trade on the false breakout, you probably would have been able to make the loss back on the next break.
Conclusion
So that is how the RSI indicator works. Some people tend to dismiss it because it is so simple. But often the simplest tools are the best.
It isn't perfect, but with some practice and testing, it might work for you. I would recommend exploring it and seeing if it fits your personality. Never trade it live without testing and demo trading it.
If you would like to get alerts in Metatrader 4, whenever RSI goes to overbought or oversold, purchase our Simple MT4 RSI Alert indicator. You can get alerts on your screen, audio sound on your computer, email, text message or push notification on your smartphone.
