Imagine having a superpower that can predict the future of currency movements, well, that’s exactly what the Relative Strength Index (RSI) Indicator does for Forex traders. By looking at recent gains and losses, the RSI can tell if a currency pair is overbought or oversold, indicating a good time to buy or sell. But that’s not all, RSI also identifies trend strength and potential trend reversals, giving traders an edge in Forex trading. This article shows you how to master Forex trading using the RSI Indicator!
Relative Strength Index (RSI) Indicator: Key Takeaways There are several benefits of using the Relative Strength Index (RSI) indicator in Forex trading, including: 1. Identifying overbought and oversold conditions: The RSI compares the magnitude of recent gains to recent losses in an attempt to determine the overbought and oversold conditions of an asset. 2. Identifying trend strength and reversals: The RSI can also be used to identify trend strength and potential trend reversals. This helps traders make better decisions about entering or exiting trades. 3. Improving risk management: Using the RSI to identify overbought and oversold conditions can help traders manage their risk better by identifying when to enter and exit trades. 4. Simple and easy to use: The RSI is a simple and easy-to-use indicator, making it accessible to traders of all experience levels. 5. Improving returns: By using the RSI to identify high-probability trade setups, traders can potentially improve their returns over time. 6. Identify Divergence: Traders can use RSI to identify divergence between price action and RSI's movement, which can be an early signal of a trend reversal. It's worth noting that the RSI is not a standalone indicator, it's important to use it in conjunction with other technical and fundamental analysis tools to make sound trading decisions.
What is the Relative Strength Index (RSI)?
The Relative Strength Index (RSI) is a technical indicator used to measure the strength of a security’s price action. It compares the magnitude of recent gains to recent losses in an attempt to determine the overbought and oversold conditions of an asset. RSI indicator is widely used in forex, stock, and other financial markets to help traders make decisions about entering and exiting trades.
The Relative Strength Index (RSI) was introduced in 1978 by Welles Wilder in his book “New Concepts in Technical Trading Systems”. In general, RSI oscillators fluctuate between 0 and 100 over a 14-day period. A value below 30 indicates oversold market conditions, while a value above 70 indicates overbought market conditions. It is commonly used by swing traders to identify short to intermediate-term price movements within a market and potential trading opportunities.
Overall, the RSI indicator is a valuable tool for traders to use in their decision-making process, providing them with key information about an asset’s price action and potential buying or selling opportunities. However, it’s recommended to use it in conjunction with other technical analysis tools such as trend lines, moving averages, and support and resistance levels to make sound trading decisions.
How to calculate Relative Strength Index (RSI) Indicator
The RSI indicator is calculated by taking the average gains over a certain period of time and dividing it by the average losses over the same period of time. The resulting number is then scaled between 0 and 100.
RSI is calculated by indexing the indicator to 100, as shown in the following RSI formula example:
RSI = 100 - (100 /1 + RS)
RS = (Average Gain / Average Loss)
To calculate the RSI, you’ll need to first determine the average gain and average loss over a specific number of periods (commonly 14 periods). Here’s how to do it:
- Determine the number of periods you want to use for the RSI calculation. Commonly 14 periods are used.
- Find the closing price for each period.
- For each period, calculate the difference between the current closing price and the previous closing price. If the difference is positive, it’s a gain, if it’s negative, it’s a loss.
- Sum up all the gains and losses for the selected number of periods.
- Divide the sum of gains by the number of periods to get the average gain.
- Divide the sum of losses by the number of periods to get the average loss.
- Use the formula to calculate the RSI indicator: RSI = 100 – (100 / (1 + (Average Gain / Average Loss)))
The resulting value will be a number between 0 and 100, which represents the relative strength of the security over the selected number of periods. A value above 70 is considered overbought, while a value below 30 is considered oversold. The RSI is a lagging indicator, it’s important to use it with other technical analysis tools to make a sound trading decision.
Example of RSI calculation for a forex pair:
Here is an example of how to calculate the Relative Strength Index (RSI) for a forex currency pair using 14 periods:
- Determine the number of periods you want to use for the RSI calculation. In this case, we’ll use 14 periods.
- Find the closing price for each period for the currency pair you’re interested in. Let’s assume the closing prices for the past 14 periods are as follows: Period 1: 1.2000, Period 2: 1.2010, Period 3: 1.2050, Period 4: 1.2040, Period 5: 1.2030, Period 6: 1.2040, Period 7: 1.2070, Period 8: 1.2090, Period 9: 1.2100, Period 10: 1.2080, Period 11: 1.2060, Period 12: 1.2050, Period 13: 1.2040, and Period 14: 1.2030.
- For each period, calculate the difference between the current closing price and the previous closing price. If the difference is positive, it’s a gain, if it’s negative, it’s a loss. Using the above closing prices, the gains and losses for the 14 periods will be: 0.0010, 0.0040, -0.0010, -0.0010, -0.0010, 0.0010, 0.0020, 0.0020, -0.0020, -0.0020, -0.0020, -0.0010, -0.0010
- Sum up all the gains and losses for the 14 periods: (0.0010) +(0.0040) +(-0.0010) +(-0.0010) +(-0.0010) +(0.0010) +(0.0020) +(0.0020) +(-0.0020) +(-0.0020) +(-0.0020) +(-0.0010) +(-0.0010) = 0.0030
- Divide the sum of gains by the number of periods to get the average gain: 0.0030 / 14 = 0.0002
- Divide the sum of losses by the number of periods to get the average loss: 0 / 14 = 0
- Use the formula to calculate the RSI indicator: RSI = 100 – (100 / (1 + (Average Gain / Average Loss))) RSI = 100 – (100 / (1 + (0.0002 / 0))) = 100
The resulting RSI value is 100, This is a special case of RSI calculation, as the RSI will be 100 if the Average loss is zero, which means that the currency pair is in an uptrend with no negative movements over the selected period.
It's important to note that this is just an example, and the RSI can be calculated for any currency pair using any number of periods. Traders should use the RSI indicator in conjunction with other technical analysis tools to make sound trading decisions.
How to set & adjust my RSI indicator in a trading chart?
A forex trader can set up the Relative Strength Index (RSI) Indicator in two different ways.
- If you’re trading forex with MetaTrader (MT4) Platform, just click on the tab ‘List of Indicators’ on the upper panel of the terminal and click on ‘Oscillators’ – ‘Relative Strength Index’.
- You can also select ‘Insert’ – ‘Indicators’ – ‘Oscillators’ – ‘Relative Strength Index (RSI)’ and simply drag and drop the indicator to the main chart window on your trading chart.
Prior to setting the indicator in the chart, an instrument configuration window will appear. You can configure the indicators parameters in this window. It defines the number of price values taken into account when plotting the main indicator’s line. It is important to remember that the shorter the period, the steeper the indicator’s chart movements. In most cases, the default setting is 14 and this setting is considered optimal.
The style settings, such as the color and weight of the lines, can also be adjusted. You can switch the levels from 30 and 70 to 20 and 80 using another tab of the configuration window. In addition, you can add new levels based on your trading style or strategy.
RSI Indicator Trading Strategies
A Relative Strength Index (RSI) Indicator is now a must-have for forex traders. However, one must learn how to use RSI indicator correctly. The following are some examples of RSI indicator settings that can be applied to different trading strategies:
1. Using RSI Signals to Open New Forex Positions
The main signal generated by the Relative Strength Index (RSI) oscillator is an indication of overbought and oversold price ranges based on the values of the data collected over time. Although RSI is commonly used as a filter in a system that uses a trend indicator as the main indicator, RSI indicator signals can also be used as a trading indicator by themselves.
RSI signals for opening positions are as follows:
- When the indicator’s line crosses level 70 from above, it’s time to open a short position (Sell).
- When the indicator’s line crosses level 30 from below, it’s time to open a long position (Buy).
In any case, it is necessary to wait for the following signal to confirm a trend reversal when the indicator’s line crosses the 70 or 30 levels.
RSI signals for closing positions are as follows:
A trade can be closed under several conditions, including:
- You should place a Stop Loss at the local extremum and a Take Profit at the value that is 2-3 times greater than the local extremum.
- Take advantage of the opposite indicator’s signal to exit.
- Set a Stop Loss and Take Profit at the nearest key levels or Fibonacci levels (The Take Profit level should not be lower than the Stop Loss level otherwise you should avoid opening the trade).
As RSI signals were designed to be used as filters, not as a main instrument, trading with RSI signals alone may not be the best approach. It is more effective to use a trend indicator or at least pay attention to Price Action signals when developing a technical trading strategy.
2. RSI Two-Period Divergence
The 2-Period RSI popularized by Larry Connors is a robust indicator for identifying mean reversion trades. In some cases, this strategy is also known as the RSI 14 strategy.
- Check for crossovers between a short 5-period RSI (RSI 5) and the longer 14-period RSI (RSI 14). When using the RSI 14 trading strategy, a market sometimes shifts direction without reaching the oversold or overbought levels. It can show early signs of reversals because a shorter period RSI is more reactive to recent price changes. An RSI 5 crossing over an RSI 14 means that recent prices are rising.
- A buy signal is generated when the 5 period (blue) is oversold (below 30). In a declining market, the RSI 5 crosses below the RSI 14 and becomes lower than it. This indicates a sell signal. The 5 vs 14 cross occurs when the 5 period (blue) is overbought (above 80).
Experienced traders are more likely to combine an RSI trading strategy with pivot points to improve their trading performance.
3. Predictive Power of RSI Trendlines
Trendlines are an essential tool in a forex trader’s arsenal. RSI indicator can also be used for trendline analysis, in which trendlines are drawn on an RSI chart to identify potential support and resistance levels.
In order to draw an upward trendline, two or more lows are connected and the line is projected into the future while the RSI is rising. As well, a downward trendline is drawn by connecting two or more highs and projecting the line into the future when the RSI is falling. When the RSI trendline breaks, a price reversal or continuation is likely to occur. Whenever an asset price breaks above a downward trendline, this signals a reversal of a downward trend in the market or a continuation of an uptrend.
RSI trendlines usually break before price chart trendlines, providing an early warning and opportunity to trade.
4. RSI Classic Divergence
An RSI bearish divergence is formed when the price forms a higher high while the RSI decreases, forming a lower high. RSI divergence usually occurs at the top of a bullish market, and this pattern is known as a reversal pattern. When RSI divergence is formed, traders expect the trend to revert. Several candlesticks appear before the uptrend reverses direction, and breaks below its support line, indicating a reversal ahead.
Conversely, a bullish divergence occurs when the RSI indicator shows a higher low and the price shows a lower low. There is a risk of the trend direction changing from downtrend to uptrend at this point. There is widespread use of RSI divergence in Forex technical analysis. Trading RSI divergence on higher time frames (H4, Daily) may be preferred by some traders. This method can help traders achieve a variety of buy and sell signals using the RSI indicator.
Best Indicator Combinations for RSI Indicator
There are many indicators that can be used in conjunction with the Relative Strength Index (RSI) to improve its effectiveness. Some popular choices are listed below.
1. Relative Strength Index (RSI) and MACD
A moving average can be used to smooth out the RSI, making it easier to identify trends and generate trading signals.
The MACD (Moving average convergence divergence) has become very popular due to its simplicity, ease of application, and graphical appeal. MACD measures the acceleration or deceleration of price trends and is used to determine when they are accelerating or decelerating. Due to its use of moving averages, MACD is primarily a lagging indicator and can be used to qualify trading signals generated by RSI, a leading indicator.
For example, when the RSI reading exceeds 70, which implies overbought conditions in the market, it’s possible to initiate a sell position when the MACD series shifts from positive to negative (crossing below the 0 centerlines).
2. Relative Strength Index (RSI) and Bollinger Bands
Bollinger Bands are a volatility indicator that can be used to identify overbought and oversold conditions in the market. They can also be used to confirm RSI signals.
Bollinger Bands determine volatility by squeezing during low volatility and diverging during high volatility. Markets are usually in a period of consolidation followed by massive breakouts, so any Bollinger Bands squeeze is critical. When RSI overbought or oversold failure swings occur, a breakout signal is delivered. For example, when the RSI line rises above 70 and then falls below 70, it is considered a bearish signal. Whenever the prices reach the lower Bollinger band, it would be a good time to open a sell position.
3. Relative Strength Index (RSI) and Stochastic Oscillator
When it comes to boosting trading efficiency, the Stochastic Oscillator is the most effective. By analyzing two timeframes simultaneously, this trading strategy compensates for the absence of trend indicators. Therefore, trades will be opened only when both oscillators give the same signal at different time frames, thereby filtering each other’s signals.
Time frames of H4 and M15 are recommended for this strategy. H4 will have the default settings for the RSI indicator. In this case, we will only set it at 50 instead of 30 and 70. Stochastic will be set by default in M15.
The following are the conditions that will trigger a short position (Sell):
- The RSI line in H4 is crossing below level 50.
- In М15, Stochastic lines enter the overbought zone and go downward.
The opposite case will result in long positions (Buy). Take Profit and Stop Loss are fixed at a distance of 80 and 20 points from the opening price. Trading with such a ratio allows for a long-term positive statistical expectation. When opening positions in this trading system, it is recommended to check the economic calendar since the release of important news can have a significant impact on price movement, and technical analysis will not be relevant at this time.
4. Relative Strength Index (RSI) and Fibonacci Indicator
Use the RSI indicator to identify overbought and oversold conditions in the market. As mentioned before, the RSI is a momentum indicator that compares the magnitude of recent gains to recent losses. It ranges between 0 and 100, with values above 70 indicating overbought conditions and values below 30 indicating oversold conditions.
Use Fibonacci retracement levels to identify key levels of support and resistance in the market. Fibonacci retracement is a technical analysis tool that uses horizontal lines to indicate areas where the price may potentially experience support or resistance. These levels are calculated based on the Fibonacci ratio, which is derived from the Fibonacci sequence.
When the RSI indicates overbought or oversold conditions and the price approaches a key Fibonacci retracement level, traders can enter a trade in the direction of the trend. Traders can use stop-loss orders to minimize potential losses and take-profit orders to secure gains. Traders can also use Fibonacci extension levels to identify potential profit targets in addition to the retracement levels.
5. Advanced Strategy: RSI + Stochastic + МА
An advanced strategy that combines the use of the Relative Strength Index (RSI), Stochastic Oscillator, and Moving Averages can be a powerful tool for traders.
Here is how the strategy works: 1. Use the RSI to identify overbought and oversold conditions in the market. The RSI is a momentum indicator that compares the magnitude of recent gains to recent losses. 2. Use the Stochastic Oscillator to confirm the overbought and oversold conditions identified by the RSI. The Stochastic Oscillator is a momentum indicator that compares the closing price to the range of prices over a specific period. 3. Use a Moving Average to identify the trend of the market. A moving average is a technical indicator that calculates the average price of a security over a specific period. It can be used to identify the direction of the trend and to generate trading signals. 4. When the RSI indicator and Stochastic Oscillator indicate overbought or oversold conditions and the moving average confirms the trend, traders can enter a trade in the direction of the trend. 5. Traders can use stop-loss orders to minimize potential losses and take-profit orders to secure gains.
The strategy is best suited for trading on the H1, H4, and D1 timeframes.
To begin, the chart needs to be set up with the following indicators:
- A moving average that has a period of 10.
- Standard RSI indicator settings (levels 70 & 30).
- Standard Stochastic oscillator settings (levels 80 & 20).
In this strategy, long positions are opened when the following signals are generated:
- The price is crossing the MA from below.
- Stochastic and RSI exit oversold territory.
It is important to receive all three signals within three candles, otherwise, their value will be lost.
It is recommended to open short positions (Sell) in the opposite scenario. RSI should be crossed into the opposite zone before exiting an open trade. It is possible to open an opposite position simultaneously with closing the previous position, allowing other signals to follow the same pattern.
How to Use the RSI Indicator for Day Trading
Day traders often benefit from using the RSI indicator in their day trading strategies. Most traders, especially swing traders, will find the default setting of 14 periods satisfactory.
However, intraday traders use the RSI indicator differently when day trading. Since the 14 setting does not generate frequent trading signals for them, they avoid using it. Instead, to increase the sensitivity of the oscillator, some traders lower their timeframe or set the RSI period to a lower value. By lowering their time frame, traders can solve this problem. Others lower the RSI period setting to make the oscillator more sensitive.
- Traders who engage in short-term intraday trading (day trading) often use lower settings with periods between 9 and 11.
- The default period setting of 14 is frequently used by medium-term swing traders.
- A longer period, between 20 and 30, is often used by traders who take positions over long periods of time.
Traders also often use custom overbought and oversold levels on the RSI when trading intraday, such as 80 and 20, or even 90 and 10. These levels are more aggressive than the traditional 70 and 30 levels and allow traders to enter trades earlier in the trend. Depending on your strategy, you can choose which settings to use with the Relative Strength Index (RSI) Indicator.
It’s worth noting it’s also important to test and back-test any strategy using the RSI indicator and the specific settings before applying them to live trades. A forex demo account can be a perfect place to test!
How to use indicators in forex technical analysis
- Identify the indicators that best suit your trading strategy: There are a variety of technical indicators available to traders, ranging from moving averages and RSI to Fibonacci retracements and Ichimoku clouds. Each indicator has its own strengths and weaknesses and is better suited for certain types of analysis than others. It’s important to identify the indicators that best suit your trading strategy and become comfortable using them.
- Choose a time frame: Different technical indicators work better on different time frames, so it’s important to determine which timeframe you want to use for your analysis. Short-term traders might opt for shorter-term indicators such as moving averages or oscillators, while longer-term traders might opt for longer-term indicators such as Fibonacci retracements or Ichimoku clouds.
- Analyze the data: Once you’ve determined which indicators to use and what time frame to use them on, it’s time to analyze the data. Look for emerging patterns and trends in the market, as well as divergence between different indicators. This will help you identify entry points and set stop-loss levels or profit targets.
- Execute trades: Once you’ve identified a potential setup in the market, it’s time to execute your trade. Make sure to follow your risk management plan and enter the trade with a clear understanding of your expected outcome.
By using technical analysis, traders can gain a better understanding of the forex market and make more informed decisions that will maximize their profits while minimizing their risks. It’s important to remember that no indicator is perfect, so combining various indicators in order to create a more accurate picture of the market is essential. With the right combination of indicators and a well-defined trading plan, traders can increase their chances of success in forex markets.
Relative Strength Index (RSI) Indicator: FAQ
What is the RSI Indicator?
The RSI is a momentum indicator that compares the magnitude of recent gains to recent losses in an effort to determine the overbought and oversold conditions of an asset. It ranges from 0 to 100, with values above 70 indicating overbought conditions and values below 30 indicating oversold conditions.
How is the RSI calculated?
The RSI is calculated using a simple mathematical formula that compares the average gains and losses over a specified period. The formula is RSI = 100 – (100 / (1 + (average gain / average loss))). To calculate the RSI, you will need to first calculate the average gains and average losses over the specified period (typically 14 days).
What are the typical settings for the RSI?
The RSI is typically calculated using a 14-day period, but it can also be calculated using other periods such as 9-day or 25-day. The overbought and oversold levels are typically set to 70 and 30 respectively. Values above 70 are considered overbought, while values below 30 are considered oversold. These levels can be adjusted based on market conditions, but 70 and 30 are commonly used.
What are the signals generated by RSI?
The RSI indicator generates signals based on overbought and oversold conditions. A value above 70 is considered overbought, while a value below 30 is considered oversold. Traders may buy when the RSI falls below 30 and then rises above it and sell when the RSI rises above 70 and then falls below it.
How do I use RSI in conjunction with other indicators?
The RSI indicator can be used in conjunction with other indicators such as moving averages, stochastic oscillators, Fibonacci retracement, etc. to confirm signals and help identify trends and key levels of support and resistance.
What’s the difference between RSI and Stochastic Oscillator?
The RSI indicator compares the magnitude of recent gains to recent losses, while the Stochastic Oscillator compares the closing price to the range of prices over a specific period. Both indicators are used to identify overbought and oversold conditions in the market, but the signals generated by these indicators can be different.